ILM II SENIOR LIVING INC /VA, 10-K/A, 1997-12-11

ILM II SENIOR LIVING INC /VA
10-K/A, 1997-12-11
REAL ESTATE INVESTMENT TRUSTS

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K/A No. 1

X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR FISCAL YEAR ENDED: AUGUST 31, 1996
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)

For the transition period from ______ to _______ .

Commission File Number: 0-18942

PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II
(now known as ILM II Senior Living, Inc.)
(Exact name of registrant as specified in its charter)

Virginia 06-1293758
- ---------(State of organization) (I.R.S. Employer
tification No.)

1285 Avenue of the Americas, New York, New York 10104
- --------------------------------------------------------------------------------
(Address of principal executive office) (Zip Code)

Registrant's telephone number, including area code: (212)713-4264
-------------

Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange on
Title of each class which registered
- ------------------- ------------------------
None None

Securities registered pursuant to Section 12(g) of the Act:

Shares of Common Stock, $.01 Par Value
(Title of class)

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. X

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No ---

Shares of common stock outstanding as of August 31, 1996: 5,181,236 (20,000 of
which were initially sold to an affiliate). The aggregate sales price of the
shares sold was $51,812,356 ($200,000 for the 20,000 shares sold to an
affiliate). This does not reflect market value. There is no current market for
these shares.

DOCUMENTS INCORPORATED BY REFERENCE
Documents Form 10-K Reference
- --------------
Prospectus of registrant dated Parts II and IV
August 8, 1990, as supplemented

Current Report on Form 8-K Part IV
of registrant dated July 29, 1996

<PAGE>

PART I

Item 1. Business (Amended to note that the Company is no longer advised by
affiliates of PaineWebber Group, Inc. and to add disclosures regarding
restrictions on the Company's borrowing ability.)

PaineWebber Independent Living Mortgage Inc. II (the "Company") is a finite-life
corporation organized on February 5, 1990 in the Commonwealth of Virginia for
the purpose of making construction and participating mortgage loans secured by
rental housing complexes for independent senior citizens ("Senior Housing
Facilities"). On September 12, 1990, the Company commenced a public offering of
up to 10,000,000 shares of common stock pursuant to a Registration Statement
filed on Form S-11 under the Securities Act of 1933 (Registration Statement No.
33-33857). On May 10, 1991, the public offering terminated. The Company issued
5,181,236 shares, representing capital contributions of $51,812,356, of which
$200,000 represented the sale of 20,000 shares to an affiliate, PaineWebber
Group, Inc. ("PaineWebber"). As of November 1, 1996, PaineWebber and its
affiliates held 123,527 shares of the Company's common stock. The Company has
elected to qualify and be taxed as a Real Estate Investment Trust ("REIT") under
the Internal Revenue Code of 1986, as amended, for each taxable year of
operations. As a REIT, the Company is allowed a deduction for the amount of
dividends paid to its shareholders, thereby effectively subjecting the
distributed net income of the Company to taxation at the shareholder level only.
In order to qualify as a REIT, the Company must distribute at least 95% of its
taxable income on an annual basis and meet certain other requirements.

The Company originally invested the net proceeds of the initial public offering
in six participating mortgage loans secured by Senior Housing Facilities located
in five different states. All of the loans made by the Company were originally
with Angeles Housing Concepts, Inc. ("AHC"), a company specializing in the
development, acquisition and operation of Senior Housing Facilities. The Company
entered into an Exclusivity Agreement with AHC and its parent company, Angeles
Corporation ("Angeles"), which required AHC to provide the Company with certain
specific opportunities to finance Senior Housing Facilities and set forth the
terms and conditions of the loans which were made. The loan documents under the
aforementioned Exclusivity Agreement called for interest to be paid on
construction loans at the rate of 13.3% per annum during the construction period
and for Base Interest to be paid on the permanent loans at the rate of 10.3% per
annum. In addition to the Base Interest, Additional Interest was to be payable
on the permanent loans in an amount equal to 10% of the Gross Revenues of the
Senior Housing Facilities, as defined. Under the terms of the amended
Exclusivity Agreement, Additional Interest was to be no less than 3% of the
aggregate principal amount of all permanent loans outstanding for the entire
term of the investments. In the aggregate, the properties securing loans from
the Company did not generate sufficient cash flow to cover the debt service
payments owed to the Company under the amended terms of the Exclusivity
Agreement. To the extent that the properties did not generate sufficient cash
flow to make the full payments due under the loan documents, the shortfall was
funded by AHC through December 1992. The source of cash to make up these
shortfalls was from specified deficit reserve accounts, which had been funded
from the proceeds of the mortgage loans, and from contributions by Angeles.

During the quarter ended February 28, 1993, Angeles announced that it was
experiencing liquidity problems that resulted in the inability to meet its
obligations. Subsequent to such announcements, AHC defaulted on the regularly
scheduled mortgage loan payments due to the Company on March 1, 1993. Subsequent
to March 1993, payments toward the debt service owed on the Company's loans were
limited to the net cash flow of the operating investment properties. On May 3,
1993, Angeles filed for reorganization under a Chapter 11 Federal Bankruptcy
petition filed in the state of California. AHC did not file for reorganization.
The Company retained special counsel and held extensive discussions with AHC
concerning the default status of its loans. During the fourth quarter of fiscal
1993, a non-binding settlement agreement between the Company, AHC and Angeles
was reached whereby ownership of the properties would be transferred from AHC to
the Company or its designated affiliates. Under the terms of the Settlement
Agreement, the Company released AHC and Angeles from certain obligations under
the loans. On April 27, 1994, each of the properties owned by AHC and securing
the Loans was transferred (collectively, "the Transfers") to newly-created
special purpose corporations affiliated with the Company (collectively, "the
Property Companies"). The Transfers had an effective date of April 1, 1994 and
were made pursuant to the Settlement Agreement entered into on February 17, 1994
("the Settlement Agreement") between the Company and AHC which had previously
been approved by the bankruptcy court handling the bankruptcy case of

I-1
<PAGE>

Angeles. All of the capital stock of each Property Company was held by ILM II
Holding, Inc. ("ILM II Holding"), a Virginia corporation. In August 1995, each
of the Property Companies merged into ILM II Holding. As a result, ownership of
the Senior Housing Facilities is now held by ILM II Holding, and the Property
Companies no longer exist as separate legal entities. Through January 10, 1997,
the capital stock of ILM II Holding was owned by the Company and PWP Holding,
Inc. ("PWP Holding"), a wholly-owned subsidiary of PaineWebber Properties
Incorporated ("PWPI"). PWPI is a wholly owned subsidiary of PaineWebber
Incorporated, which is a wholly owned subsidiary of PaineWebber Group, Inc.
("PaineWebber"). The Company held substantially all of the economic ownership in
ILM II Holding, while PWP Holding held voting control. As discussed further
under Item 7, on November 21, 1996 the Company requested that PWPI cause PWP
Holding to sell all of the stock held by PWP Holding in ILM II Holding to the
Company for a price equal to the fair market value of the 1% economic interest
in ILM II Holding represented by the common stock. On January 10, 1997, this
transfer of the common stock of ILM II Holding was completed at an agreed upon
fair value of $40,000.

As part of the fiscal 1994 settlement agreement with AHC, ILM II Holding
retained AHC as the property manager for all of the Senior Housing Facilities
pursuant to the terms of a management agreement. As discussed further in Item 7,
the management agreement with AHC was terminated in July 1996.

Subsequent to the effective date of the Settlement Agreement with AHC,
management investigated and evaluated the available options for structuring the
ownership of the properties in order to maximize the potential returns to the
existing shareholders while maintaining the Company's qualification as a REIT
under the Internal Revenue Code. To retain REIT status, the Company must ensure
that 75% of its annual gross income is received from qualified sources. Under
the original investment structure, interest income from the Company's mortgage
loans was a qualified source. The properties that are now owned by an affiliate
of the Company are Senior Housing Facilities that provide tenants with more
services, such as meals, activities, assisted living, etc., than are customary
for ordinary residential apartment properties. As a result, a significant
portion of the rents paid by the tenants includes income for the increased level
of services received by them. Consequently, the rents paid by the tenants likely
would not be qualified rents for REIT qualification purposes if received
directly by the Company. Therefore, if the Company received such rents directly,
it could lose REIT status and be taxed as a regular corporation. After extensive
review, the Board of Directors determined that it would be in the best interests
of the shareholders for the Company to retain REIT status and master lease the
properties to a shareholder-owned operating company. As discussed further in
Item 7, on September 12, 1994 the Company formed a new subsidiary, ILM II Lease
Corporation, for the purpose of operating the Senior Housing Facilities. The
Senior Housing Facilities were leased to ILM II Lease Corporation effective
September 1, 1995 (see Item 7 for a description of the master lease agreement).

The Company's investments as of August 31, 1996 are described below:

Property Name Date of
and Location (1) Type of Property Investment Size
- ---------------- ---------------- ---------- ----

The Palms
Fort Myers, FL Senior Housing Facility 7/18/90 204
Units

Crown Villa
Omaha, NE Senior Housing Facility 4/25/91 73 Units

Overland Park Place
Overland Park, KS Senior Housing Facility 4/9/92 137
Units
I-2
<PAGE>

Rio Las Palmas
Stockton, CA Senior Housing Facility 5/14/92 162
Units

The Villa at Riverwood
St. Louis County, MO Senior Housing Facility 5/29/92 119
Units

Villa Santa Barbara (2)
Santa Barbara, CA Senior Housing Facility 7/13/92 123
Units

(1) See Notes to the Financial Statements filed with this Annual Report for a
description of the agreements through which the Company has acquired these
real estate investments.

(2) The acquisition and improvement of the Santa Barbara facility was jointly
financed by the Company and an affiliated company, PaineWebber Independent
Living Mortgage Fund, Inc. (ILM1). Any amounts generated by the operations
of the Santa Barbara property are equitably apportioned between the Company,
together with its affiliate, and ILM1, together with its affiliate
(generally 75% and 25%, respectively).

The Senior Housing Facilities are subject to competition from similar properties
in the vicinities in which they are located. The properties are located in areas
with significant senior citizen populations and, as a result, there are, and
will likely continue to be, a variety of competing projects aimed at attracting
senior residents. Such projects will generally compete on the basis of rental
rates, services, amenities and location. The Company has no real estate
investments located outside the United States. The Company is engaged solely in
the business of real estate investment. Therefore, presentation of information
about industry segments is not applicable.

The Company originally expected to liquidate its investments after a period of
approximately ten years, although under the terms of its organizational
documents property sales may occur at earlier or later dates. The Board of
Directors may defer the Company's scheduled liquidation date, if in the opinion
of a majority of the Directors, the disposition of the Company's assets at such
time would result in a material under-realization of the value of such assets;
provided, however, that no such deferral may extend beyond December 31, 2005.
The net proceeds of any sale transactions are expected to be distributed to the
Shareholders, so that the Company will, in effect, be self-liquidating.

Under certain circumstances it may be advantageous for the Company to borrow
funds to meet its investment objectives and maximize return to shareholders. The
Company's bylaws provide that the Company may not incur indebtedness if, after
giving effect to the incurrence of debt thereof, aggregated indebtedness,
secured and unsecured, would exceed 300% of the Company's net assets on a
consolidated basis, as calculated at the end of each calendar quarter in
accordance with generally accepted accounting principles.

In addition to the foregoing, the Company may incur indebtedness in order to
prevent default under loans or to discharge them entirely if this becomes
necessary to protect the Company's investment. This may occur if foreclosure
proceedings are instituted by the holder of a mortgage interest which is senior
to that held by the Company, although the Company does not anticipate entering
into loans that are subject to such senior mortgage interests. In addition, the
Company may incur indebtedness in order to assist in the operation of any
property acquired by the Company as a result of a default on a loan made by the
Company secured by the property to protect such loan.

Through June 18, 1997 and subject to the supervision of the Company's Board of
Directors, assistance in the management of the business of the Company was
provided by PaineWebber ILM Advisor, L.P. (the "Advisor"), a limited partnership
comprised of ILM REIT Advisor, Inc., a Virginia corporation, and Properties
Associates, L.P., a Virginia limited partnership. ILM REIT Advisor, Inc. is a
wholly owned subsidiary of PWPI. The partners of the Advisor are affiliates of
PWI and PaineWebber.

I-3

<PAGE>

As discussed further in Item 7, the Company has accepted the resignation of the
Advisor, effective as of June 18, 1997. The Advisor agreed to continue to
provide certain administrative services to the Company and its affiliates
through August 31, 1997, pursuant to the terms of a transition services
agreement entered into with the Company and its affiliates. The Company and its
affiliates have also accepted, effective as of June 18, 1997, the resignations
of those officers and directors who are employees of or otherwise affiliated
with the Advisor or its affiliates. Subsequent to resignation of the Advisor and
affiliated persons, the Board of Directors engaged a former employee of PWPI as
a consultant to assist in the management of the Company. The Company is
currently evaluating various strategic alternatives, including the possibility
of becoming self-managed.

Subsequently to June 18, 1997, there are five directors of the Company, none of
whom is an affiliate of the Advisor. The directors are subject to removal by the
vote of the holders of a majority of the outstanding shares. The directors are
responsible for the general policies of the Company, but they are not required
to personally conduct the business of the Company in their capacities as
directors.

The terms of transactions between the Company and the Advisor and its affiliates
are set forth in Items 11 and 13 below to which reference is hereby made for a
description of such terms and transactions.

Item 3. Legal Proceedings (Amended to update the status of litigation since the
date of the original filing.)

On July 29, 1996, ILM II Lease Corporation and ILM II Holding, Inc. ("the
Companies") terminated the property management agreement with Angeles Housing
Concepts, Inc. ("AHC") covering the eight senior housing facilities leased by
ILM II Lease Corporation from ILM II Holding, Inc., the Company's equity
investee. The management agreement was terminated for cause pursuant to Sections
1.05 (a) (i), (iii) and (iv) of the agreement. Simultaneously with the
termination of the management agreement, the Companies, together with certain
affiliated entities, filed suit against AHC in the United States District Court
for the Eastern District of Virginia for breach of contract, breach of fiduciary
duty and fraud. ILM II Lease Corporation and ILM II Holding, Inc. allege that
AHC willfully performed actions specifically in violation of the management
agreement and that such actions caused damages to the Companies. Due to the
termination of the agreement for cause, no termination fee was paid to AHC.
Subsequent to the termination of the management agreement, AHC filed for
protection under Chapter 11 of the U.S. Bankruptcy Code in its domestic state of
California. The filing was challenged by the Companies, and the Bankruptcy Court
dismissed AHC's case effective October 15, 1996. In November 1996, AHC filed
with the Virginia District Court an Answer in response to the litigation
initiated by the Companies and a Counterclaim against ILM II Holding, Inc. The
Counterclaim alleges that the management agreement was wrongfully terminated for
cause and requests damages which include the payment of the termination fee in
the amount of $750,000, payment of management fees pursuant to the contract from
August 1, 1996 through October 15, 1996, which is the earliest date that the
management agreement could have been terminated without cause, and recovery of
attorney's fees and expenses. PaineWebber Independent Living Mortgage Fund, Inc.
II guaranteed the payment of the termination fee at issue in these proceedings.
The court initially set a trial date of April 28, 1997 but, at AHC's request,
rescheduled the trial for June 23, 1997. On June 13, 1997 and July 8, 1997, the
court issued Orders purporting to enter judgment against the Company and
PaineWebber Independent Living Mortgage Fund, Inc. (ILM I) in the amount of
$1,000,000. In so doing, the court effectively canceled the June 23, 1997 trial
date. The Orders did not contain any findings of fact or conclusions of law. On
July 10, 1997, the Company, ILM I, ILM I Lease Corporation and ILM II Lease
Corporation filed a notice of appeal to the United State Court of Appeals for
the Fourth Circuit. The Company intends to diligently prosecute the appeal. The
eventual outcome of this litigation cannot presently be determined. However, as
reported in the Company's report on Form 10-Q for the quarter ended May 31,
1997, the Company has recorded a provision in the amount of $400,000 for the
liability which might result from the court's Orders.

I-4
<PAGE>

At a Board meeting on February 26, 1997, the Company's Board of Directors
concluded that since all of Mr. Cohen's actions relating to the California
litigation were taken either on behalf of the Company under the direction of the
Board or as a PaineWebber Properties employee, the Company or its affiliates
should indemnify Mr. Cohen with respect to any expenses arising from the
California litigation, subject to any insurance recoveries for those expenses.
The Company's Board also concluded that, subject to certain conditions, the
Company or its affiliates should advance up to $20,000 to pay reasonable legal
fees and expenses incurred by Capital in the California litigation.
Subsequently, the Boards of Directors of ILM I Lease Corporation and ILM II
Lease Corporation voted to increase the maximum amount of the advance to
$100,000. The defendants intend to vigorously defend the claims made against
them in the California litigation. The eventual outcome of this litigation
cannot presently be determined and, accordingly, no provision for any liability
has been recorded in the accompanying financial statements.

In November 1994, a series of purported class actions (the "New York Limited
Partnership Actions") were filed in the United States District Court for the
Southern District of New York concerning PaineWebber Incorporated's sale and
sponsorship of various limited partnership interests and common stock, including
the securities offered by the Company. The lawsuits were brought against
PaineWebber Incorporated and Paine Webber Group, Inc. (together, "PaineWebber"),
among others, by allegedly dissatisfied investors. In March 1995, after the
actions were consolidated under the title In re PaineWebber Limited Partnership
Litigation, the plaintiffs amended their complaint to assert claims against a
variety of other defendants, including PaineWebber Properties Incorporated
("PWPI"), an affiliate of PaineWebber and the parent company of the general
partner of the Advisor to the Company. On May 30, 1995, the court certified
class action treatment of the claims asserted in the litigation.

The amended complaint in the New York Limited Partnership Actions alleged that,
in connection with the sale of common stock of the Company, the defendants (1)
failed to provide adequate disclosure of the risks involved; (2) made false and
misleading representations about the safety of the investments and the Company's
anticipated performance; and (3) marketed the Company to investors for whom such
investments were not suitable. The plaintiffs, who purported to be suing on
behalf of all persons who invested in the Company also alleged that following
the issuance of the Company's stock, the defendants misrepresented financial
information about the Company's value and performance. The amended complaint
alleged that the defendants violated the Racketeer Influenced and Corrupt
Organizations Act ("RICO") and the federal securities laws. The plaintiffs
sought unspecified damages, including reimbursement for all sums invested by
them in the Company's stock, as well as disgorgement of all fees and other
income derived by PaineWebber from the Company. In addition, the plaintiffs also
sought treble damages under RICO.

In January 1996, PaineWebber signed a memorandum of understanding with the
plaintiffs in the class action outlining the terms under which the parties have
agreed to settle the case. Pursuant to that memorandum of understanding,
PaineWebber irrevocably deposited $125 million into an escrow fund under the
supervision of the United States District Court for the Southern District of New
York to be used to resolve the litigation in accordance with a definitive
settlement agreement and a plan of allocation. On July 17, 1996, PaineWebber and
the class plaintiffs submitted a definitive settlement agreement which has been
preliminarily approved by the court and provides for the complete resolution of
the class action litigation, including releases in favor of the Company and
PWPI, and the allocation of the $125 million settlement fund among investors in
the various partnerships and REITs at issue in the case. As part of the
settlement, PaineWebber also agreed to provide class members with certain
financial guarantees relating to some of the partnerships and REITs. The details
of the settlement are described in a notice mailed directly to class members at
the direction of the court. A final hearing on the fairness of the proposed
settlement was held in December 1996, and in March 1997 the court announced its
final approval of the settlement. The release of the agreed upon settlement
proceeds had been delayed pending the resolution of an appeal of the settlement
agreement by two of the plaintiff class members. In July, 1997, the United
States Court of Appeals for the Second Circuit upheld the settlement over the
objections of the two class members. As part of the settlement agreement,
PaineWebber agreed not to seek indemnification from the related partnerships and
REITs at issue in the litigation (including the Company)for any amounts it is
required to pay under the settlement.

I-5

<PAGE>

concerning the plaintiffs' purchases of various limited partnership investments
and REIT stocks, including those offered by the Company. The complaint alleges,
among other things, that PaineWebber and its related entities committed fraud
and misrepresentation and breached fiduciary duties allegedly owed to the
plaintiffs by selling or promoting limited partnership and REIT investments that
were unsuitable for the plaintiffs and by overstating the benefits, understating
the risks and failing to state material facts concerning the investments. The
complaint seeks compensatory damages of $15 million plus punitive damages. In
September 1996, the court dismissed many of the plaintiffs' claims as barred by
applicable securities arbitration regulations.

In June 1996, approximately 50 plaintiffs filed an action entitled Bandrowski v.
PaineWebber Inc. in Sacramento, California Superior Court against PaineWebber
Incorporated and various affiliated entities concerning the plaintiff's
purchases of various limited partnership interests and REIT stocks, including
those offered by the Company. The complaint is substantially similar to the
complaint in the Abbate action described above, and seeks compensatory damages
of $3.4 million plus punitive damages.

In July 1996, approximately 15 plaintiffs filed an action entitled Barstad v.
PaineWebber Inc. in Maricopa County, Arizona Superior Court against PaineWebber
Incorporated and various affiliated entities concerning the plaintiffs'
purchases of various limited partnership interests and REIT stocks, including
those offered by the Company. The complaint is substantially similar to the
complaint in the Abbate action described above, and seeks compensatory damages
of $752,000 plus punitive damages.

In December 1996 PaineWebber agreed to settle the Abbate, Bandrowski and Barstad
actions. Final releases and dismissals with regard to these actions were
received during fiscal 1997.

Based on these settlement agreements which cover all of the outstanding
shareholder litigation, management does not expect that the resolution of the
shareholder matters will have a material impact on the Company's financial
statements, taken as a whole.

I-6
<PAGE>

PART II

Item 6. Selected Financial Data (Amended to be consistent with amended financial
statements included in Item 14.)

PaineWebber Independent Living Mortgage Inc. II

For the years ended August 31, 1996, 1995,
1994, 1993 and 1992 (in thousands except
per unit data)

1996 1995 1994 1993 1992
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>

Revenues ..................... $ 46 $ 87 $ 72 $ 211 $ 2,088

Operating income ............. $ (587) $ (877) $ (769) $ (457) $ 1,209

Gain on sale of mortgage-
backed security ........... -- -- -- -- $ 1,100

Gain on sale of Treasury Note- -- -- -- $ 87 --

Equity in income (losses)
from properties securing
mortgage loans ............ $ 2,674 $ 2,308 $ 1,957 $ 567 $ (340)

Net income ................... $ 2,087 $ 1,431 $ 1,188 $ 197 $ 1,969

Earnings per
share of common
stock ....................... $ 0.40 $ 0.27 $ 0.23 $ 0.04 $ 0.38

Cash dividends paid
per share of common
stock ....................... $ 0.50 $ 0.43 $ 0.40 $ 0.70 $ 1.00

Total assets ................. $ 33,973 $ 35,052 $ 35,382 $ 36,234 $ 40,737

</TABLE>

The above selected financial data should be read in conjunction with the
financial statements and related notes appearing elsewhere in this Annual
Report.

The above earnings and cash dividends paid per share of common stock are based
upon the 5,181,236 shares outstanding during each year.

Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations (Amended to be consistent with amended financial statements
included in Item 14, to reflect changes in ownership subsequent to the original
filing, and to note the resignation of the Advisor effective June 18, 1997.)

Liquidity and Capital Resources

The Company offered shares of its common stock to the public from September 12,
1990 to May 10, 1991 pursuant to a Registration Statement filed under the
Securities Act of 1933. Capital contributions of $51,812,356

II-1

<PAGE>

were received by the Company (including $200,000 contributed by PaineWebber
Group, Inc.) and, after deducting selling expenses and offering costs and
allowing for adequate cash reserves, approximately $42.9 million was available
to be invested in participating first mortgage loans secured by Senior Housing
Facilities. The Company originally invested the net proceeds of the initial
public offering in six participating mortgage loans secured by Senior Housing
Facilities located in five different states. All of the loans made by the
Company were originally with Angeles Housing Concepts, Inc. ("AHC"), a company
specializing in the development, acquisition and operation of Senior Housing
Facilities. As previously reported, AHC defaulted on the regularly scheduled
mortgage loan payments due to the Company on March 1, 1993 as a result of the
financial problems of its parent company, Angeles Corporation ("Angeles"), which
subsequently filed for bankruptcy. In fiscal 1994, a settlement agreement was
executed whereby ownership of the properties was transferred from AHC to certain
designated affiliates of the Company. Subsequently, these affiliates were merged
into ILM II Holding, Inc. ("ILM II Holding"). The capital stock of ILM II
Holding is owned by the Company and PWP Holding, Inc. ("PWP Holding"), a
wholly-owned subsidiary of PaineWebber Properties Incorporated ("PWPI"). PWPI is
a wholly owned subsidiary of PaineWebber Incorporated, which is a wholly owned
subsidiary of PaineWebber Group, Inc. ("PaineWebber"). The Company held
substantially all of the economic ownership in ILM II Holding, while PWP Holding
held voting control. As discussed further under Item 7, on November 21, 1996 the
Company requested that PWPI cause PWP Holding to sell all of the stock held by
PWP Holding in ILM II Holding to the Company for a price equal to the fair
market value of the 1% economic interest in ILM II Holding represented by the
common stock. On January 10, 1997, this transfer of the common stock of ILM II
Holding was completed at an agreed upon fair value of $40,000. As part of the
fiscal 1994 settlement agreement with AHC, ILM II Holding retained AHC as the
property manager for all of the Senior Housing Facilities pursuant to the terms
of a management agreement. As discussed further below, the management agreement
with AHC was terminated in July 1996.

Subsequent to the effective date of the Settlement Agreement with AHC, in order
to maximize the potential returns to the existing shareholders while maintaining
the Company's qualification as a REIT under the Internal Revenue Code, the
Company formed a new corporation, ILM II Lease Corporation, for the purpose of
operating the Senior Housing Facilities under the terms of a master lease
agreement. As of August 31, 1995, ILM II Lease Corporation, which is taxable as
a regular C Corporation and not as a REIT, was a wholly-owned subsidiary of the
Company. On September 1, 1995, after the Company received the required
regulatory approval, it distributed all of the shares of capital stock of ILM II
Lease Corporation to the holders of record of the Company's common stock. One
share of common stock of ILM II Lease Corporation was issued for each full share
of the Company's common stock held. Prior to the distribution, the Company
capitalized ILM II Lease Corporation with $500,000 from its existing cash
reserves, which was an amount estimated to provide ILM II Lease Corporation with
necessary working capital. The master lease agreement, which commenced on
September 1, 1995, is initially between the Company's equity investee, ILM II
Holding, as owner of the properties and Lessor, and ILM II Lease Corporation as
Lessee. The master lease is a "triple-net" lease whereby the Lessee pays all
operating expenses, governmental taxes and assessments, utility charges and
insurance premiums, as well as the costs of all required maintenance, personal
property and non-structural repairs in connection with the operation of the
Senior Housing Facilities. ILM II Holding, as the Lessor, is responsible for all
major capital improvements and structural repairs to the Senior Housing
Facilities. During the initial term of the master lease, which expires on
December 31, 2000 (December 31, 1999 with respect to the Santa Barbara
property), ILM II Lease Corporation is obligated to pay annual base rent for the
use of all of the Facilities in the aggregate amount of $3,548,700 for calendar
year 1995 (prorated based on the lease commencement date) and $4,035,600 for
calendar year 1996 and each subsequent year. Beginning in January 1997 and for
the remainder of the lease term, ILM I Lease Corporation will also be obligated
to pay variable rent for each Facility. Such variable rent will be payable
quarterly and will equal 40% of the excess, if any, of the aggregate total
revenues for the Facilities, on an annualized basis, over $13,021,000.

The assumption of ownership of the properties through ILM II Holding has
resulted in a possible future tax liability which would be payable upon the
ultimate sale of the properties (the "built-in gain tax"). The amount of such
tax would be calculated based on the lesser of the total net gain realized from
the sale transaction or the portion of the net gain realized upon a final sale
which is attributable to the period during which the properties were held by a C
corporation. The final phase of the Company's restructuring plans involves the
conversion of ILM II Holding to a REIT for tax purposes. Certain changes to the
ownership structure of ILM II Holding which

II-2

<PAGE>

are necessary in order for ILM II Holding to qualify as a REIT under the
Internal Revenue Code are expected to be made in time for ILM II Holding to
elect REIT status in conjunction with the filing of its calendar 1996 federal
tax return. Any future appreciation in the value of the Senior Housing
Facilities subsequent to the conversion of ILM II Holding to a REIT would not be
subject to the built-in gain tax. The built-in gain tax would most likely not be
incurred if the properties were to be held for a period of at least 10 years
from the date of the conversion of ILM II Holding to a REIT. However, since the
end of the Company's original anticipated holding period is less than 5 years
away, the properties are not expected to be held for an additional 10 years. The
Board of Directors may defer the Company's scheduled liquidation date, if in the
opinion of a majority of the Directors, the disposition of the Company's assets
at such time would result in a material under-realization of the value of such
assets; provided, however, that no such deferral may extend beyond December 31,
2005. Based on management's current estimate of the increase in the values of
the properties which has occurred since April 1994, as supported by independent
appraisals, ILM II Holding would incur a sizable tax if the properties were
sold. Based on these current estimated market values of the operating investment
properties, a sale at such values prior to the end of the 10-year holding period
could result in a built-in gain tax of as much as $2.3 million. As the holder of
a 99% economic interest in ILM II Holding, the burden of this built-in gain tax
would be primarily borne by the Company.

On July 29, 1996, ILM II Lease Corporation and ILM II Holding ("the Companies")
terminated the property management agreement with AHC covering the eight senior
housing facilities leased by ILM II Lease Corporation from ILM II Holding. The
management agreement was terminated for cause pursuant to the terms of the
contract. Simultaneously with the termination of the management agreement, the
Companies filed suit against AHC in the United States District Court for the
Eastern District of Virginia for breach of contract, breach of fiduciary duty
and fraud. ILM II Lease Corporation and ILM II Holding allege that AHC willfully
performed actions specifically in violation of the management agreement and that
such actions caused damages to the Companies. Due to the termination of the
agreement for cause, no termination fee was paid to AHC. Subsequent to the
termination of the management agreement, AHC filed for protection under Chapter
11 of the U.S. Bankruptcy Code in its domestic state of California. The filing
was challenged by the Companies, and the Bankruptcy Court dismissed AHC's case
effective October 15, 1996. In November 1996, AHC filed with the Virginia
District Court an Answer in response to the litigation initiated by the
Companies and a Counterclaim against ILM II Holding. The Counterclaim alleges
that the management agreement was wrongfully terminated for cause and requests
damages which include the payment of the termination fee in the amount of
$750,000, payment of management fees pursuant to the contract from August 1,
1996 through October 15, 1996, which is the earliest date that the management
agreement could have been terminated without cause, and recovery of attorney's
fees and expenses. PaineWebber Independent Living Mortgage Inc. II guaranteed
the payment of the termination fee at issue in these proceedings. The court
initially set a trial date of April 28, 1997 but, at AHC's request, rescheduled
the trial for June 23, 1997. On June 13, 1997 and July 8, 1997, the court issued
Orders purporting to enter judgment against the Company and PaineWebber
Independent Living Mortgage Fund, Inc. (ILM I) in the amount of $1,000,000. In
so doing, the court effectively canceled the June 23, 1997 trial date. The
Orders did not contain any findings of fact or conclusions of law. On July 10,
1997, the Company, ILM I, ILM I Lease Corporation and ILM II Lease Corporation
filed a notice of appeal to the United States Court of Appeals for the Fourth
Circuit. The Company intends to diligently prosecute the appeal. The eventual
outcome of this litigation cannot presently be determined. However, as reported
in the Company's report on Form 10-Q for the quarter ended May 31, 1997, the
Company has recorded a provision in the amount of $400,000 for the liability
which might result from the court's Orders.

ILM II Lease Corporation has retained Capital Senior Management 2, Inc.
("Capital") of Dallas, Texas to be the new manager of the Senior Housing
Facilities pursuant to a Management Agreement which commenced on July 29, 1996.
Under the terms of the Agreement, Capital will earn a Base Management Fee equal
to 4% of the Gross Operating Revenues of the Senior Housing Facilities, as
defined. Capital will also be eligible to earn an Incentive Management Fee equal
to 25% of the amount by which the average monthly Net Cash Flow of the Senior
Housing Facilities, as defined, for the twelve month period ending on the last
day of each calendar month exceeds a specified Base Amount. Each August 31,
beginning on August 31, 1997, the Base Amount will be increased annually based
on the percentage increase in the Consumer Price Index. PaineWebber Independent
Living

II-3

<PAGE>

Mortgage Inc. II has guaranteed the payment of all fees due to Capital under the
terms of the Management Agreement.

The Company has been attempting to continue its restructuring plans by
converting ILM II Holding to a real estate investment trust ("REIT") for tax
purposes. In connection with these plans, on November 21, 1996 the Company
requested that PWPI cause PWP Holding to sell all of the stock held by PWP
Holding in ILM II Holding to the Company for a price equal to the fair market
value of the 1% economic interest in ILM II Holding represented by the common
stock. On January 10, 1997, this transfer of the common stock of ILM II Holding
was completed at an agreed upon fair value of $40,000. With this transfer
completed, effective January 23, 1997 ILM II Holding recapitalized its common
stock and preferred stock by replacing the outstanding shares with 50,000 shares
of new common stock and 275 shares of a new class of nonvoting, 8% cumulative
preferred stock issued to the Company. The number of authorized shares of
preferred and common stock in ILM II Holding were also increased as part of the
recapitalization. Following the recapitalization, the Company made charitable
gifts of one share of the preferred stock in ILM II Holding to each of 111
charitable organizations so that ILM II Holding would meet the stock ownership
requirements of a REIT as of January 30, 1997. The preferred stock has a
Liquidation Preference of $1,000 per share plus any accrued and unpaid
dividends. Dividends on the preferred stock will accrue at a rate of 8% per
annum on the original $1,000 Liquidation Preference and will be cumulative from
the date of issuance. Since ILM II Holding is not expected to have sufficient
cash flow in the foreseeable future to make the required dividend payments, it
is anticipated that dividends will accrue and be paid at liquidation.

At a Board meeting on January 10, 1997, the Advisor at that point in time
recommended the immediate sale of the senior housing facilities held by the
Company and an affiliated entity, PaineWebber Independent Living Mortgage Fund,
Inc. ("ILM I"), by means of a controlled auction to be conducted by PaineWebber,
at no additional compensation, with PaineWebber offering to purchase the
properties for $127 million, thereby guaranteeing the shareholders a "floor"
price. The Advisor also stated that if PaineWebber purchased the properties at
the specified price and were then able to resell the properties at a higher
price, PaineWebber would pay any "excess profits" to the shareholders. To assist
the Company and ILM II Lease Corporation (see Note 2) in evaluating the
Advisor's proposal, a disinterested, independent investment banker with
expertise in healthcare REITs and independent/assisted living financings was
engaged. Following comprehensive analysis, the investment banker recommended
that the Company decline the Advisor's proposal and instead investigate
expansion and restructuring alternatives. After analyzing the Advisor's proposal
and the recommendations and other information provided by the independent
investment banker, the Boards of the Company and ILM I voted unanimously to
decline the Advisor's proposal and to explore the alternatives recommended by
the independent investment banker. The Boards declined to seek an immediate sale
of the properties because, in the Boards' view, the liquidation price would not
reflect the "going concern" value of the Company and ILM I and, therefore, would
not maximize shareholder value. In addition, the Boards did not consider it
advisable to liquidate the Company and ILM I on the suggested terms three years
prior to their scheduled termination date.

The Advisor had indicated to the Board in its January 10, 1997 proposal that it
would not wish to continue to serve as advisor to the Company and its affiliates
if the Company declined to accept the Advisor's proposal. The Company has
accepted the resignation of the Advisor, effective as of June 18, 1997. The
Advisor has agreed to continue to provide certain administrative services to the
Company and its affiliates through August 31, 1997, pursuant to the terms of a
transition services agreement entered into with the Company and its affiliates.
The Company and its affiliates have also accepted, effective as of June 18,
1997, the resignations of those officers and directors who are employees of or
otherwise affiliated with the Advisor or its affiliates. Subsequent to
resignation of the Advisor and affiliated persons, the Board of Directors
engaged a former employee of PWPI as a consultant to assist in the management of
the Company. The Company is currently evaluating various strategic alternatives,
including the possibility of becoming self-managed.

In addition, the Company and ILM II Lease Corporation are continuing to review
various restructuring alternatives that could further increase shareholder value
and liquidity. The Company and ILM II Lease Corporation are analyzing a merger
of the Company with ILM II Holding and are also considering possibly merging the
Company with ILM I and ILM I Lease Corporation with ILM II Lease Corporation. In
addition, the Company is exploring listing its shares on an exchange or,
alternatively, having them trade through NASDAQ.

II-4

<PAGE>

The independent investment banker is also in the process of developing a new
reorganization proposal. The Company has not fully evaluated any of these
alternatives and is not in a position at this time to recommend any actions to
the shareholders. There can be no assurance that the Company will recommend
taking any of such actions.

The six properties in which the Company has invested averaged 93% occupancy as
of August 31, 1996. As previously reported, a property renovation and
assisted-living conversion program has been in progress at Villa Santa Barbara
for the past two years. Phase one of the renovations at the Santa Barbara
facility, which was completed during fiscal 1995, included renovation of the
lobby, dining room, library, activities room, television and game room and the
laundry rooms. Phase two of the renovation program, which was substantially
completed during the first quarter of fiscal 1996, involved interior unit
improvements, hallway upgrades and the conversion of existing studio units to
assisted living units. The total cost of the renovation program was
approximately $1.2 million, which has been funded 75% by the Company and 25% by
PaineWebber Independent Living Mortgage Fund, Inc. ("ILM1") from funds
previously reserved for such improvements. Leasing gains at Villa Santa Barbara
have been slowed by delays in completing the capital improvements and in
obtaining the required regulatory licensing to begin leasing the new assisted
living units. During the quarter ended May 31, 1996, ILM II Lease Corporation
received the required assisted living licenses. Leasing of the 38 new assisted
living units is now well underway. Overall occupancy of Villa Santa Barbara
averaged 81% for the fourth quarter of fiscal 1996.

The Company's net operating cash flow is expected to be relatively stable and
predictable now that the master lease structure is in place. The annual base
rental payments owed to ILM II Holding increased to $4,035,600 effective January
1, 1996 and will remain at that level for the remainder of the lease term. In
addition, the Senior Housing Facilities are currently generating gross revenues
which are slightly in excess of the specified threshold in the variable rent
calculation, as discussed further above, which becomes effective in January
1997. Accordingly, the Company expects that ILM II Holding will receive variable
rent payments in fiscal 1997. As a result of the status of the Company's net
operating cash flow under the current master lease arrangement, the Company is
expected to be able to increase its quarterly dividend payment from $0.125 per
share to $0.1625 per share effective with the dividend to be paid in January
1997 for the quarter ended November 30, 1996. This expected increase would raise
the dividend payment to the equivalent of a 6.5% annual return on the original
offering price of the Company's common stock. As noted above, ILM II Holding, as
Lessor, is responsible for capital improvements and structural repairs to the
Senior Housing Facilities. Management is currently reviewing with the new
property management team annual operating budgets and capital expenditure plans
which include an ongoing program to replace air-conditioning units at the Santa
Barbara facility, planned roof repairs at Overland Park Place and The Palms and
the completion of a program to upgrade the common areas at the Rio Las Palmas
property. In addition, management plans to continue its investigation of the
potential for the expansion of the assisted living capacities of the properties
in certain markets where demand for assisted living units is particularly high.
Depending on the extent of any assisted living expansions deemed appropriate,
such plans could result in the need for substantial capital improvement funds.

As reported in the Company's report on Form 10-Q for the quarter ended May 31,
1997, the Company's Board of Directors has concluded that obtaining control of
adjacent land for future expansion purposes could add significant value to
certain of its properties. The Fort Myers property already includes
approximately 1.5 acres of developable land purchased in 1995. During 1997, the
Company entered into agreements to purchase land adjacent to the Stockton and
Omaha properties. In addition, the Company is in the process of obtaining a
credit facility of up to $15 million from a major bank which can be used to fund
its expansion plans.

At August 31, 1996, the Company had cash and cash equivalents of $1,449,000.
Such amounts will be used for the working capital requirements of the Company,
along with the possible investment in the properties owned by the Company's
consolidated affiliate for certain capital improvements, and for dividends to
the shareholders. Future capital improvements could be financed from operations
or through borrowings, depending on the magnitude of the improvements, the
availability of financing and the Company's incremental borrowing rate. The
source of future liquidity and dividends to the shareholders is expected to be
through master lease payments from ILM II Lease Corporation, interest income
earned on invested cash reserves and proceeds from the future sales of

II-5

<PAGE>

the underlying operating investment properties. Such sources of liquidity are
expected to be adequate to meet the Company's operating requirements on both a
short-term and long-term basis. The Company generally will be obligated to
distribute annually at least 95% of its taxable income to its Shareholders in
order to continue to qualify as a REIT under the Internal Revenue Code.

Results of Operations

1996 Compared to 1995
- ---------------------

Net income increased by $656,000 for fiscal 1996 when compared to the prior
year. A primary reason for this increase in net income is the commencement of
the master lease between the Company's equity investee, ILM II Holding, Inc. and
ILM II Lease Corporation effective September 1, 1995, as discussed further above
and in the notes to the accompanying financial statements. ILM II Holding, Inc.
now receives master lease rental income from ILM II Lease Corporation rather
than the revenues from the individual tenants of the Senior Housing Facilities.
In addition, under the terms of the master lease, all property operating
expenses are now the responsibility of the Lessee. The master lease rental
income earned by ILM II Holding, Inc. during fiscal 1996 was $305,000 more than
the excess of rental income earned from the Senior Housing Facilities over
property management fees and property operating expenses during the prior year.
In addition, management and advisory fees incurred by ILM II Holding, Inc.
decreased as the advisory fees charged in 1995 and prior years was no longer
applicable upon commencement of the master lease.

The Company's operating loss decreased as a result of decreases in professional
fees, general and administrative expense, insurance expense and amortization
expense. Professional fees decreased by $295,000 as a result of the significant
amount of legal and tax advisory services incurred in the prior year in
connection with the evaluation, selection and implementation of the master lease
property ownership structure described above. Amortization expense decreased by
$6,000 as organization costs became fully amortized during 1995.

A decrease of $41,000 in interest income partially offset the favorable changes
to operating loss described above. Interest income decreased due to a decline in
the average amount of cash and cash equivalents outstanding when compared to the
prior year.

1995 Compared to 1994
- ---------------------

The Company's equity in income of ILM II Holding, Inc. increased by $351,000 as
ILM II Holding, Inc. generated rental revenues of $11,789,000 for fiscal 1995,
as compared to $10,863,000 for the prior year. This increase of $926,000, or 9%,
was the primary reason that the Company's net income improved from $1,188,000
for fiscal 1994 to $1,431,000 for fiscal 1995. The increase in rental revenues
was mainly the result of increased occupancy at Villa Santa Barbara and an
increase in effective rental rates at certain of the Facilities. Overall
portfolio occupancy increased slightly from an average of 87% for fiscal 1994 to
88% for fiscal 1995. The biggest leasing gain was achieved at Villa Santa
Barbara, which despite its slower than anticipated leasing pace, did improve
from an average occupancy of 48% for fiscal 1994 to an average occupancy of 59%
for fiscal 1995. In addition, slight leasing gains were achieved at the Overland
Park and Riverwood properties during fiscal 1995. Average occupancy at Overland
Park improved to 96% for fiscal 1995 from an average level of 95% for the prior
year. Likewise, average occupancy at Riverwood increased to 96% from 95% over
the same period. The occupancy level at the Rio Las Palmas property dropped
during fiscal 1995 to an average of 73% from a level of 75% for the prior year.
With the exception of Rio Las Palmas and Villa Santa Barbara, the other four
properties all maintained average occupancy levels of 95% or better during each
of the past two years. However, revenues were up at these stabilized properties
in fiscal 1995 because management was able to implement rental rate increases
while maintaining stable occupancy levels.

Property operating expenses increased by $384,000, or 5%, for fiscal 1995,
partially offsetting the improvement in revenues. The increase in property
operating expenses was primarily attributable to higher variable food service,
housekeeping, activities and assisted living costs associated with the overall
increase in the portfolio occupancy level. However, the change in property
operating expenses also reflected a decrease in marketing costs at certain

II-6

<PAGE>

of the Facilities that had achieved stabilized occupancy levels and the effects
of certain operating efficiencies implemented at most of the Facilities
subsequent to the transfers of ownership to the Property Companies. Increases in
management and advisory fees incurred by ILM II Holding, Inc. of $83,000, also
served to offset the increase in revenues from the Senior Housing Facilities.
Management and advisory fees increased as a result of the new advisory agreement
between ILM II Holding, Inc. and an affiliate of PWPI. Such agreement, which was
effective from April 1, 1994 through August 31, 1995, called for fees equal to
0.5% of the Gross Operating Revenues of the Facilities in return for certain
administrative services.

The Company's operating loss increased by $108,000, primarily due to an increase
in professional fees as a result of certain legal and tax advisory services
required in connection with the evaluation, selection and implementation of the
master lease property ownership structure described above.

1994 Compared to 1993
- ---------------------

The Transfers of the Senior Housing Facilities from AHC to the Property
Companies in fiscal 1994 resulted in no gain or loss recognition by the Company
for financial reporting purposes. As previously reported, under generally
accepted accounting principles, the Company has always accounted for its
investments in acquisition and construction loans under the equity method, as
if such investments were equity interests in a joint venture. Accordingly, the
carrying values of such investments have been reduced since inception by
non-cash depreciation charges and by payments from AHC, prior to the default in
fiscal 1993, in excess of the net cash flow generated by the Senior Housing
Facilities received pursuant to the guaranty agreement between the Company and
AHC. As a result of this accounting treatment, the carrying values of the
Company's investments had been reduced below management's estimate of the fair
market value of the Senior Housing Facilities as of the effective date of the
Transfers. Accordingly, for financial reporting purposes the Company has
continued to employ its historical cost basis in accounting for these
investments subsequent to the Transfers and has continued to record its share
of the operating results of the properties in its statement of income. For
federal income tax purposes, the investments have always been carried at the
contractually stated principal balances of the Loans. For tax purposes only, a
loss will be recognized by the Company in 1994 in the amount by which the
stated principal balances of the Loans were reduced as of the date of the
Transfers.

The Company's net income increased by approximately $991,000 for fiscal
1994, as compared to fiscal 1993. This favorable change in net income is mainly
due to an improvement in the Company's share of the operating results of the
properties securing its acquisition and construction loans. This improvement is
generally the result of increased occupancy and increased rental income at most
of the Senior Housing Facilities. Overall portfolio occupancy increased to 88%
as of August 31, 1994 from its level of 81% one year earlier. In addition,
several properties which have reached stabilized occupancy levels have
successfully implemented rental rate increases on all units. A decrease in the
aggregate depreciation expense recognized for all of the Facilities also
contributed to the improvement in the net operating results of the properties
securing the Company's acquisition and construction loans in fiscal 1994. The
decrease in depreciation expense is primarily attributable to the change in the
depreciable basis of the fixed assets which occurred upon the transfer of the
properties from AHC to the Property Companies. The Property Companies recorded
the depreciable basis of the properties based on the historical cost basis of
the Company's investments in the operating properties as of April 1, 1994. Such
basis was significantly lower than the historical cost basis of AHC, mainly due
to the reduction in basis recognized by the Company as a result of payments
made by AHC pursuant to its guaranty agreement with the Company. As noted
above, the Company's net historical cost basis was lower than management's
estimate of the fair market value of the investment properties as of the
effective date of the Transfers. The favorable change in the operating results
of the Senior Housing Facilities was partially offset by an increase in the
Company's operating loss of approximately $312,000. This increase in operating
loss was partly due to a decrease in interest income of approximately $138,000,
due to the Company's temporary investment during fiscal 1993 in a United States
Government Treasury Note, which was sold in August of 1993 at a gain of
approximately $87,000.

II-7

<PAGE>

In addition, there was an increase in professional fees of approximately
$187,000 in fiscal 1994, primarily due to legal fees related to the AHC loan
defaults and management's efforts to protect the Company's interest in the
underlying collateral. This was partially offset by a reduction in management
fee expense. Management fee expense decreased by approximately $32,000 in
fiscal 1994 due to the reduction in the quarterly dividend, beginning with the
quarter ended February 28, 1993, from $0.25 per share to $0.10 per share. The
dividend reduction, resulting from the circumstances described above with
respect to the loan defaults, reduced the shareholders' rate of return on
original shareholders' equity to below 10% per annum. Accordingly, the Advisor
has not earned any incentive management fees since the first quarter of fiscal
1993.

Inflation
- ---------

The Company completed its fifth full year of operations in fiscal 1996. The
effects of inflation and changes in prices on the Company's operating results to
date have not been significant.

Inflation in future periods is likely to cause increases in the Company's
expenses, which may be partially offset by increases in revenues from the
Company's investments in the Senior Housing Facilities. Under the terms of the
master lease, as discussed further above, the Company's equity investee, ILM II
Holding, will earn additional rental income based on increases in the gross
revenues of the related operating properties beginning in January 1997. Such
gross revenues may tend to rise with inflation since the rental rates on the
tenant leases, which are short-term in nature, can be adjusted to keep pace with
inflation as market conditions allow.

Item 8. Financial Statements and Supplementary Data (Amended as described under
Item 14.)

The financial statements and supplementary data are included under Item 14 of
this Annual Report.

II-8

<PAGE>

PART III

Item 10. Directors and Executive Officers of the Registrant (Amended to note
resignation of the Advisor and affiliated persons effective June 18, 1997.)

Effective after June 18, 1997, there are five directors of the Company, none of
whom is an affiliate of the Advisor. The directors are subject to removal by the
vote of the holders of a majority of the outstanding shares. The directors are
responsible for the general policies of the Company, but they are not required
to personally conduct the business of the Company in their capacities as
directors.

(a) and (b) The names and ages of the directors and executive officers of the
Company are as follows:

Date
elected
Age to
Name Office Office
- ---- ------ ------

Lawrence A. Cohen President, Chief Executive
Officer and Director 43 5/15/91
Jeffry R. Dwyer Director 50
2/12/90*
J. William Sharman, Jr. Director 56
2/12/90*
Carl J. Schramm Director 50 12/5/96
Julien G. Redele' Director 61 12/5/96
Walter V. Arnold** Senior Vice President, Chief
Financial Officer
and Treasurer 49
2/12/90*
James A. Snyder** Senior Vice President 51 7/06/92
C. David Carlson** Vice President 48
12/11/95
Dorothy F. Haughey** Secretary 70 2/12/90*

* The date of incorporation of the Company.

** The Company has accepted the resignation of the Advisor effective as of June
18, 1997. The Advisor has agreed to continue to provide certain administrative
services to the Company and its affiliates through August 31, 1997, pursuant to
the terms of a transition services agreement entered into with the Company and
its affiliates. The Company and its affiliates have also accepted, effective as
of June 18, 1997, the resignations of those officers and directors who are
employees of or otherwise affiliated with the Advisor or its affiliates.

(c) Through June 18, 1997, ILM REIT Advisor, Inc., the general partner of the
Advisor, assisted the directors and officers of the Company in the management
and control of the Company's affairs. ILM REIT Advisor, Inc. was a wholly-owned
subsidiary of PaineWebber Properties Incorporated ("PWPI"). The principal
executive officers of ILM REIT Advisor, Inc. were as follows:

Name Office Age
- ---- ------ ---

Bruce J. Rubin President and Chief Executive Officer 37
Walter V. Arnold Senior Vice President, Chief
Financial Officer and Treasurer 49
James A. Snyder Senior Vice President 51
C. David Carlson Vice President 48

(d) There is no family relationship among any of the foregoing directors or
officers. All of the foregoing directors and officers of the Company have been
elected to serve until the Company's next annual meeting.

III-1

<PAGE>

(e) The business experience of each of the directors and executive officers of
the Company and ILM REIT Advisor, Inc. is as follows:

Lawrence A. Cohen has served as President, Chief Executive Officer and Director
of the Company since 1991. Mr. Cohen is also Vice Chairman and Chief Financial
Officer of Capital Senior Living Corp., an affiliate of Capital Senior
Management 2, Inc., which is the company that was contracted by ILM II Lease
Corporation in July 1996 to perform property management services for the Senior
Housing Facilities in which the Company has invested. Mr. Cohen joined Capital
Senior Living Corp. in November 1996. Mr. Cohen was President and Chief
Executive Officer of PWPI until August 1996. Mr. Cohen joined PWPI in January
1989 as its Executive Vice President and Director of Marketing and Sales. Mr.
Cohen is also a member of the board of directors of PaineWebber Independent
Living Mortgage Fund, Inc. (ILM I), ILM I Lease Corporation, ILM II Lease
Corporation and Retail Property Investors, Inc. (RPI). Mr. Cohen received his
LL.M (in Taxation) from New York University School of Law and his J.D. degree
from St. John's University School of Law. Mr. Cohen received his B.B.A. degree
in accounting from George Washington University. He is a member of the New York
Bar and is a Certified Public Accountant.

Jeffry R. Dwyer has served as a director of the Company since its inception in
1990. Mr. Dwyer is a partner with the law firm of Akin, Gump, Straus, Hauer &
Feld in the District of Columbia, which he joined in 1993. Prior to joining
Akin, Gump, Straus, Hauer & Feld, Mr. Dwyer was a partner with the law firm of
Morrison & Foerster from 1989 to 1993. Immediately prior to joining Morrison &
Foerster, Mr. Dwyer was a partner with the law firm of Lane & Edson. Mr. Dwyer
also presently serves as a director of ILMI, ILM I Lease Corporation and ILM II
Lease Corporation. Mr. Dwyer has written several books on real estate financing
and taught Real Estate Planning as an Adjunct Professor at the Georgetown
University Law Center. Mr. Dwyer graduated from Georgetown University and
received his law degree from the Georgetown University Law Center.

J. William Sharman, Jr. has served as a director of the Company since its
inception in 1990. Mr. Sharman is the Chairman of the Board and President of
Lancaster Hotel Management, L.C., a hotel management company, and Bayou
Equities, Inc., a hotel development company. Mr. Sharman served for ten years as
Chairman of the Board and President of The Lancaster Group, Inc., a real estate
development firm based in Houston, Texas, which is the predecessor of Lancaster
Hotel Management, L.C. and Bayou Equities, Inc. Mr. Sharman is Vice Chairman of
Small Luxury Hotels, Ltd. of the United Kingdom, an international hotel
marketing and reservations firm. Mr. Sharman also presently serves as a director
of ILMI and RPI. He has a Bachelor of Science degree in Civil Engineering from
the University of Notre Dame.

Carl J. Schramm was appointed to fill a newly created seat on the Company's
Board of Directors as of December 5, 1996. Mr. Schramm is President of
Greenspring Advisors, Inc., a consulting and investment advisory firm serving
clients in the managed care, health insurance and health information industries.
From 1993 to 1995, Mr. Schramm served as Executive Vice President of Fortis,
Inc., a diversified insurance and financial services company. From 1987 through
1992, Mr. Schramm was President of the Health Insurance Association of America,
the national trade association of commercial health underwriters. Mr. Schramm
currently serves on the boards of HCIA, Inc., LifeRate Systems, Inc., the
Rochdale Insurance Group, Physicians Health Corporation and Madison Information
Technologies. Mr. Schramm holds a Ph.D. in Economics from the University of
Wisconsin and received his J.D. from Georgetown University.

Julien G. Redele' was appointed to fill a newly created seat on the Company's
Board of Directors as of December 5, 1996. Mr. Redele' is one of the original
founders of SFRE, Inc., a Dutch owned real estate investment and development
firm which has served since 1963 as advisor to Dutch institutional, corporate
and individual investors active in the United States. Mr. Redele' serves as a
director of the Island Preservation Partnership. Mr. Redele' attended
Westersingel Business School, Rotterdam, where he studied economics, law and
finance.

Bruce J. Rubin was named President and Chief Executive Officer of PWPI in August
1996. Mr. Rubin joined PaineWebber Real Estate Investment Banking in November
1995 as a Senior Vice President. Prior to joining PaineWebber, Mr. Rubin was
employed by Kidder, Peabody and served as President for KP Realty Advisers,

III-2

<PAGE>

Inc. Prior to his association with Kidder, Mr. Rubin was a Senior Vice President
and Director of Direct Investments at Smith Barney Shearson. Prior thereto, Mr.
Rubin was a First Vice President and a real estate workout specialist at
Shearson Lehman Brothers. Prior to joining Shearson Lehman Brothers in 1989, Mr.
Rubin practiced law in the Real Estate Group at Willkie Farr & Gallagher. Mr.
Rubin is a graduate of Stanford University and Stanford Law School.

Walter V. Arnold was a Senior Vice President, Chief Financial Officer and
Treasurer of the Company and is Senior Vice President and Chief Financial
Officer of PWPI which he joined in October 1985. Mr. Arnold joined PWI in 1983
with the acquisition of Rotan Mosle, Inc. where he had been First Vice President
and Controller since 1978, and where he continued until joining PWPI. Mr. Arnold
is a Certified Public Accountant licensed in the state of Texas.

James A. Snyder was a Senior Vice President of the Company and is a Senior Vice
President of PWPI. Mr. Snyder re-joined PWPI in July 1992 having served
previously as an officer of PWPI from July 1980 to August 1987. From January
1991 to July 1992, Mr. Snyder was with the Resolution Trust Corporation, where
he served as the Vice President of Asset Sales prior to re-joining PWPI. From
February 1989 to October 1990, he was President of Kan Am Investors, Inc., a
real estate investment company. During the period August 1987 to February 1989,
Mr. Snyder was Executive Vice President and Chief Financial Officer of Southeast
Regional Management Inc., a real estate development company.

C. David Carlson was a Vice President of the Company and a Vice President of
PWPI which he joined in December 1995. From 1987 through 1995, Mr. Carlson was
an officer in Belmont Properties, Inc., a Boston-based real estate investment,
development and advisory firm. Mr. Carlson graduated from the University of
Minnesota in 1977 and received a Master of Science in Real Estate Development
degree from the Massachusetts Institute of Technology in 1986. In 1997, Mr.
Carlson left PWPI and currently serves as a consultant to the Company.

Dorothy F. Haughey was Secretary of the Company and is Assistant Secretary of
PaineWebber and Secretary of PWI and PWPI. Ms. Haughey joined PaineWebber in
1962.

(f) None of the directors and officers was involved in legal proceedings which
are material to an evaluation of his or her ability or integrity as a director
or officer.

(g) Compliance With Exchange Act Filing Requirements: The Securities Exchange
Act of 1934 requires the officers and directors of the Company, and persons who
own more than ten percent of the Company's outstanding common stock, to file
certain reports of ownership and changes in ownership with the Securities and
Exchange Commission. Officers, directors and ten-percent beneficial holders are
required by SEC regulations to furnish the Company with copies of all Section
16(a) forms they file.

Based solely on its review of the copies of such forms received by it, the
Company believes that, during the year ended August 31, 1996, all filing
requirements applicable to its officers and directors and ten-percent beneficial
holders were complied with.

Item 13. Certain Relationships and Related Transactions (Amended to reflect the
resignation of the Advisor effective June 18, 1997.)

Through June 18, 1997 (see Item 10) and subject to the supervision of the
Company's Board of Directors, assistance with the management of the business of
the Company was provided by PaineWebber ILM Advisor, L.P. (the "Advisor"), a
limited partnership comprised of ILM REIT Advisor, Inc., a Virginia corporation,
and Properties Associates, L.P. ("PA"), a Virginia limited partnership. ILM REIT
Advisor, Inc. is a wholly owned subsidiary of PaineWebber Properties
Incorporated ("PWPI"). In addition, the limited partners and holders of certain
assignee interests of PA are or have been also officers of PWPI. PWPI is a
wholly owned subsidiary of

III-3

<PAGE>

PaineWebber Incorporated ("PWI"). PWI is a wholly owned subsidiary of
PaineWebber Group Inc., ("PaineWebber").

For its services in finding and recommending investments, PWPI received a
mortgage placement fee equity to 2% of the capital contributions of the company.
Mortgage placement fees totaling $1,036,248 were earned by PWPI during the
Company's investment acquisition period. In connection with construction loans,
a construction loan administration fee of 1% of each construction loan was paid
by AHC to PWPI or its affiliates for administering such loan. In connection with
acquisition loans, a due diligence fee of 1% of the principal amount of each
such loan was paid by AHC to PWPI for conducting due diligence activities. Loan
administration and due diligence fees totaling $425,141 were paid to PWPI during
the Company's investment acquisition period.

AHC received an investment fee for providing the Company with the opportunity to
invest the available proceeds of the offering in loans. The investment fee is an
amount equal to 0.75% of the offering proceeds, and was payable on the date of
the Initial Closing. Investment fees earned by AHC totaled $388,603.

AHC received a research and analysis fee in connection with the offering equal
to 1% of the capital contributions for identifying and analyzing development and
acquisition opportunities for Senior Housing Facilities and for reimbursements
of certain expenses associated with those activities. The research and analysis
fee paid to AHC totaled $518,123.

The Advisor was entitled to receive 1% of Disposition Proceeds, as defined,
until the shareholders have received dividends of Net Cash equal to their
Adjusted Capital Investments, as defined, plus a 12% non-compounded annual
return on their Adjusted Capital Investments; all Disposition Proceeds
thereafter until the Advisor has received an aggregate of 5% of Disposition
Proceeds; and, thereafter, 5% of Disposition Proceeds.

Under the Advisory Agreement, the Advisor had specific management
responsibilities; to perform day-to-day operations of the Company and to act as
the investment advisor and consultant for the Company in connection with general
policy and investment decisions. The Advisor will receive an annual Base Fee and
an Incentive Fee of 0.25% and 0.25%, respectively, of the capital contributions
of the Company, as defined, as compensation for such services. Incentive Fees
are subordinated to shareholders' receipt of distributions of net cash
sufficient to provide a return equal to 10% per annum. The Advisor earned base
management fees totaling $130,000 for the year ended August 31, 1996. Payment of
incentive management fees was suspended effective April 15, 1993 in conjunction
with a reduction in the Company's quarterly dividend payments.

The Advisor and its affiliates were reimbursed for their direct expenses
relating to the offering of Shares, the administration of the Company and the
acquisition and operations of the Company's real estate investments.

An affiliate of the Advisor performs certain accounting, tax preparation,
securities law compliance and investor communications and relations services for
the Company. Total costs incurred by this affiliate in providing these services
are allocated among several entities, including the Company. Included in general
and administrative expenses on the accompanying statement of income for the year
ended August 31, 1996 is $107,000, representing reimbursements to this affiliate
for providing such services to the Company.

Mitchell Hutchins Institutional Investors, Inc. ("Mitchell Hutchins") provided
cash management services with respect to the Company's cash assets. Mitchell
Hutchins is a subsidiary of Mitchell Hutchins Asset Management, Inc., an
independently operated subsidiary of PaineWebber. Mitchell Hutchins earned
$6,000 (included in general and administrative expenses) for managing the
Company's cash assets during fiscal 1996. Fees charged by Mitchell Hutchins are
based on a percentage of invested cash reserves which varies based on the total
amount of invested cash which Mitchell Hutchins manages on behalf of PWPI.

III-4

<PAGE>

PART IV

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(Amended to account for the Company's investment in ILM II Holding, Inc. using
the equity method, to clarify the Company's obligation under its guaranty
related to the Angeles termination fee litigation, to include an unaudited
footnote regarding events subsequent to the date of the independent auditors
report, and to include the separate financial statements of ILM II Holding,
Inc.)

(a) The following documents are filed as part of this report:

(1) and (2) Financial Statements and Schedules:

The response to this portion of Item 14 is submitted as a
separate section of this report. See Index to Financial
Statements and Financial Statement Schedules at page F-1.

(3) Exhibits:

The exhibits listed on the accompanying index to exhibits at
page IV-3 are filed as part of this Report.

(b) The Company filed a Current Report on Form 8-K dated July 29, 1996
reporting the termination by ILM II Lease Corporation of the property
management agreement with Angeles Housing Concepts, Inc. and the
retention of Capital Senior Management 2, Inc. as the new property
manager.

See (a)(3) above.

(d) Financial Statement Schedules:

The response to this portion of Item 14 is submitted as a
separate section of this report. See Index to Financial
Statements and Financial Statement Schedules at page F-1.

IV-1

<PAGE>

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

PAINEWEBBER INDEPENDENT
LIVING MORTGAGE INC. II

By: /s/ Lawrence A. Cohen
Lawrence A. Cohen
President and Chief Executive
Officer

Dated: November 7, 1997

IV-2

<PAGE>

ANNUAL REPORT ON FORM 10-K
Item 14(a)(3)

PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II

INDEX TO EXHIBITS

Page Number in the
Exhibit No. Description of Document Report or Other Reference
- ---------- ----------------------- --------------------------
<S> <C> <C>

(3) and (4) Prospectus of the Registrant dated August 8, 1990, Filed with the
as supplemented, with particular reference to the Commission pursuant to
Restated Certificates and Agreement of Limited Rule 424c and
Partnership. incorporated herein
by reference.

(10) Material contracts previously filed as exhibits to Filed with the
registration statements and amendments thereto Commission pursuant to
of the registrant together with all such contracts Section 13 or 15d of the
filed as exhibits of previously filed Form 8-K and Securities Exchange
Forms 10-K are hereby incorporated by reference. Act of 1934 and
incorporated herein by
reference.

Contracts regarding retention by ILM II Lease Filed as exhibits 1 and 2
Corporation of Capital Senior Management 2, to the Current Report on
Inc., as property manager. Form 8-K dated July 29,
1996 and incorporated
herein by reference.

(13) Annual Reports to Stockholders No Annual Reports for
the year ended August 31, 1996
has been sent to the Stockholders.
An Annual Report will be sent to
the Stockholders subsequent to this
filing.

(27) Financial Data Schedule Filed as the last page of
EDGAR submission
following the Financial
Statements and Financial
Statement Schedule
required by Item 14.

</TABLE>

IV-3

<PAGE>

ANNUAL REPORT ON FORM 10-K
Item 14(a)(1) and (2) and 14(d)
PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II
INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES

Reference

PaineWebber Independent Living Mortgage Inc. II:

Report of independent auditors F-2

Balance sheets as of August 31, 1996 and 1995 F-3

Statements of income for the years ended
August 31, 1996, 1995 and 1994 F-4

Statements of changes in shareholders' equity
for the years ended August 31, 1996, 1995 and 1994 F-5

Statements of cash flows for the years ended
August 31, 1996, 1995 and 1994 F-6

Notes to financial statements F-7

ILM II Holding, Inc.

Report of independent auditors F-22

Balance sheets as of August 31, 1996 and 1995 F-23

Statements of income for the year ended
August 31, 1996, the two month period ended
August 31, 1995 and the year ended June 30, 1995 F-24

Statements of changes in shareholders' equity
for the year ended August 31, 1996, the two month
period ended August 31, 1995 and the year
ended June 30, 1995 F-25

Statements of cash flows for the year
ended August 31, 1996, the two month
period ended August 31, 1995 and the year ended
June 30, 1995 F-26

Notes to financial statements F-27

Schedule III - Real Estate and Accumulated Depreciation F-33

Other schedules have been omitted since the required information is not
present or not present in amounts sufficient to require submission of the
schedule, or because the information required is included in the financial
statements, including the notes thereto.

F-1

<PAGE>

REPORT OF INDEPENDENT AUDITORS

The Shareholders of
PaineWebber Independent Living Mortgage Inc. II

We have audited the accompanying balance sheets of PaineWebber
Independent Living Mortgage Inc. II as of August 31, 1996 and 1995, and the
related statements of income, changes in shareholders' equity, and cash flows
for each of the three years in the period ended August 31, 1996. These financial
statements and are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and based
on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present
fairly, in all material respects, the financial position of PaineWebber
Independent Living Mortgage Inc. II at August 31, 1996 and 1995, and the results
of its operations and its cash flows for each of the three years in the period
ended August 31, 1996, in conformity with generally accepted accounting
principles.

As described in Note 2, the financial statements as of August 31, 1996
and 1995 and for each of the three years ended August 31, 1996 have been
restated to account for the Company's investment in and construction loans to
ILM II Holding, Inc. on the equity method.

/S/ERNST & YOUNG LLP
ERNST & YOUNG LLP

Boston, Massachusetts
December 10, 1996
Except for Note 2 to which
the date is September 30, 1997

F-2

<PAGE>

PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II

BALANCE SHEETS
August 31, 1996 and 1995
(In thousands, except per share amounts)

1996 1995
--------------------------
ASSETS

Investment in and construction
loans to ILM II Holding, Inc. $32,173 $33,177
Cash and cash equivalents 1,449 1,679
Accounts receivable - affiliates - 156
Interest and other receivables 350 32
Prepaid expenses and other assets 1 8
-------------- -----------------

$33,973 $35,052
============== =================

LIABILITIES AND SHAREHOLDERS' EQUITY

Accounts payable - affiliates $ 32 $ 57
Accounts payable and accrued expenses 65 115
-------------- -----------------

Total liabilities 97 172

Shareholders' equity:
Common stock, $0.01 par value, 12,500,000
shares authorized, 5,181,236 shares
issued and outstanding 52 52
Additional paid-in capital
(net of offering costs) 44,823 44,823
Accumulated deficit (10,999) (9,995)
-------------- -----------------

Total shareholders' equity 33,876 34,880
-------------- -----------------

$33,973 $35,052
============== =================

See accompanying notes.

F-3

<PAGE>

PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II

STATEMENTS OF INCOME
For the years ended August 31, 1996, 1995 and 1994
(In thousands, except per share amounts)

1996 1995 1994
--------------------------------------

Revenues:
Interest income earned
on cash equivalents $ 46 $ 87 $ 72

Expenses:
Management fees 130 130 130
General and administrative 226 248 270
Insurance expense 20 28 32
Professional fees 233 528 379
Director compensation 24 24 24
Amortization expense - 6 6
--------------------------------------
633 964 841
--------------------------------------
Operating loss (587) (877) (769)

Equity in income of properties
securing construction loans 2,674 2,308 1,957
------------ -------------------------

Net income: $2,087 $1,431 $ 1,188
======================================

Earnings per share of common stock $0.40 $ 0.27 $ 0.23
======================================
Cash dividends paid per share
of common stock $0.50 $ 0.43 $ 0.40
======================================

The above earnings and cash dividends paid per share of common stock
are based upon the 5,181,236 shares outstanding during each year.

See accompanying notes.

F-4

<PAGE>

PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II

STATEMENTS OF CHANGES IN SHAREHOLDERS'
EQUITY For the years ended August 31, 1996,
1995 and 1994
(In thousands, except per share amounts)

Common Stock Additional
$.01 Par Value Paid-in Accumulated
Shares Amount Capital Deficit Total
------------------------------------------------------------
<S> <C> <C> <C> <C> <C>

Shareholders' equity
at August 31, 1993 5,181,236 $52 $44,823 $(8,764) $36,111
Cash dividends paid -- -- -- (2,072) (2,072)
Net income -- -- -- 1,188 1,188
-----------------------------------------------------------

Shareholders' equity
at August 31, 1994 5,181,236 52 44,823 (9,648) 35,227
Cash dividends paid -- -- -- (2,202) (2,202)
Net income -- -- -- 1,431 1,431
Adjustment to eliminate
reporting lag for investee's
operations (Note4) -- -- -- 424 424
-----------------------------------------------------------

Shareholders' equity
at August 31, 1995 5,181,236 52 44,823 (9,995) 34,880
Cash dividends paid -- -- -- (2,591) (2,591)
Distribution of stock in ILM II
Lease Corporation (Note 1) -- -- -- (500) (500)
Net income -- -- -- 2,087 2087
-----------------------------------------------------------

Shareholders' equity
at August 31, 1996 5,181,236 $52 $44,823 $10,999) $33,876
==========================================================

</TABLE>

See accompanying notes.

F-5

<PAGE>

PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II

STATEMENTS OF CASH FLOWS For
the years ended August 31, 1996, 1995 and
1994
Increase (Decrease) in Cash and Cash Equivalents
(In thousands)

1996 1995 1994
-----------------------------------
<S> <C> <C> <C>

Cash flows from operating activities:
Net income $ 2,087 $ 1,431 $ 1,188
Adjustments to reconcile net income to
net cash provided by operating activities:
Equity in income of properties securing
construction loans (2,674) (2,308) (1,957)
Amortization expense -- 6 6
Changes in assets and liabilities:
Interest and other receivables (318) (29) (3)
Accounts receivable-affiliates 156 (143) 71
Prepaid expenses 7 (8) 29
Accounts payable - affiliates (25) (2) (26)
Accounts payable and accrued expenses (50) 17 58
-----------------------------------
Total adjustments (2,904) (2,467) (1,822)
-----------------------------------
Net cash used in operating activities (817) (1,036) (634)

Cash flows from investing activities
Funding of initial working capital to
ILM II Lease Corporation (500) -- --
Net proceeds from settlement of claims with Angeles
Corporation and affiliates -- 948 --
Additional fundings of construction loans (320) (587) (969)
Contractual payments received under construction
loans to ILM II Holding, Inc. 3,998 3,176 2,164
-----------------------------------
Net cash provided by investing activities 3,178 3,537 1,195

Cash flows from financing activities:
Cash dividends paid to shareholders (2,591) (2,202) (2,072)
-----------------------------------
Net cash used in financing activities (2,591) (2,202) (2,072)

Net (decrease) increase in cash and cash equivalents (230) 299 (1,511)

Cash and cash equivalents, beginning of year 1,679 1,380 2,891
-----------------------------------
Cash and cash equivalents, end of year $ 1,449 $ 1,679 $ 1,380
===================================
Cash paid for state income taxes $ 3 $ 3 $ 3
===================================

</TABLE>

See accompanying notes.

F-6

<PAGE>

PAINEWEBBER INDEPENDENT LIVING MORTGAGE INC. II

Notes to Financial Statements

1. Nature of Operations

PaineWebber Independent Living Mortgage Inc. II (the "Company") was organized as
a corporation on February 5, 1990 under the laws of the State of Virginia. On
September 12, 1990, the Company commenced a public offering of up to 10,000,000
shares of its common stock at $10 per share, pursuant to a Registration
Statement filed on Form S-11 under the Securities Act of 1933 (Registration
Statement No. 33-33857). The public offering terminated on May 10, 1991 with a
total of 5,181,236 shares issued. The Company received capital contributions of
$51,812,356, of which $200,000 represented the sale of 20,000 shares to an
affiliate, Paine Webber Group, Inc. ("PaineWebber"). As of November 1, 1996,
PaineWebber and its affiliates held 123,527 shares of the Company's common
stock. The Company has elected to qualify and be taxed as a Real Estate
Investment Trust ("REIT") under the Internal Revenue Code of 1986, as amended,
for each taxable year of operations (see Note 2).

F-7

<PAGE>

Incorporated ("PWPI"). PWPI is a wholly owned subsidiary of PaineWebber
Incorporated, which is a wholly owned subsidiary of PaineWebber Group, Inc.
("PaineWebber").

The Company holds substantially all of the economic ownership in ILM II Holding,
while PWP Holding holds voting control. ILM II Holding issued 100 shares of
Series A Preferred Stock to the Company in return for a capital contribution in
the amount of $495,000 and issued 10,000 shares of Common Stock to PWP Holding
in return for a capital contribution in the amount of $5,000. The holders of the
Series A Preferred Stock are entitled to one vote for each share of Preferred
Stock held. In addition, the holders of the Series A Preferred Stock are
entitled to receive, when and if declared by the Board of Directors, dividends
and distributions in an aggregate amount equal to 99% of the total amount of
dividends and distributions made to all shareholders. The holders of the Common
Stock are entitled to one vote for each share of Common Stock held. The holders
of the Common Stock are entitled to receive, when and if declared by the Board
of Directors, dividends and distributions in an aggregate amount equal to 1% of
the total amount of dividends and distributions made to all shareholders. As
part of the fiscal 1994 settlement agreement with AHC, ILM II Holding retained
AHC as the property manager for all of the Senior Housing Facilities pursuant to
the terms of a management agreement. As discussed further in Note 5, the
management agreement with AHC was terminated in July 1996. Subsequent to the
effective date of the Settlement Agreement with AHC, management investigated and
evaluated the available options for structuring the ownership of the properties
in order to maximize the potential returns to the existing shareholders while
maintaining the Company's qualification as a REIT under the Internal Revenue
Code (see Note 2). As discussed further in Note 4, on September 12, 1994 the
Company formed a new subsidiary, ILM II Lease Corporation, for the purpose of
operating the Senior Housing Facilities. The Senior Housing Facilities were
leased to ILM II Lease Corporation effective September 1, 1995 (see Note 4 for a
description of the master lease agreement).

2. Change in Accounting Principle

The financial statements of ILM II Holding were previously consolidated with
those of the Company for financial reporting purposes because the Company has
substantially all the economic ownership in ILM II Holding. However, because the
Company does not hold majority voting control, it determined that accounting for
its investment in ILM II Holding using the equity method would be more
appropriate. As a result, the accompanying financial statements have been
restated to account for the Company's investment in ILM II Holding using the
equity method. Under the equity method, the Company's investment in ILM II
Holding is carried at cost, including the face amount of the mortgage loans,
adjusted for the Company's share of ILM II Holding's earnings, losses and
distributions.

3. Use of Estimates and Summary of Significant Accounting Policies

The accompanying financial statements have been prepared on the accrual basis of
accounting in accordance with generally accepted accounting principles which
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosures of contingent assets and
liabilities as of August 31, 1996 and 1995 and revenues and expenses for each of
the three years in the period ended August 31, 1996. Actual results could differ
from the estimates and assumptions used.

F-8

<PAGE>

A. BASIS OF PRESENTATION

The operating cycle in the real estate industry is longer than one year and
the distinction between current and non-current is of little relevance.
Accordingly, the accompanying balance sheets are presented in an unclassified
format.

B. INCOME TAXES

The Company has elected to qualify and to be taxed as a Real Estate
Investment Trust ("REIT") under the Internal Revenue Code of 1986, as
amended, for each taxable year of operations. As a REIT, the Company is
allowed a deduction for the amount of dividends paid to its shareholders,
thereby effectively subjecting the distributed net taxable income of the
Company to taxation at the shareholder level only, provided it distributes at
least 95% of its taxable income and meets certain other requirements for
qualifying as a real estate investment trust. In connection with the
settlement agreement described in Note 1, the Company, through its
consolidated affiliate, obtained title to the properties securing its
mortgage loan investments. To retain REIT status, the Company must ensure
that 75% of its annual gross income is received from qualified sources. Under
the original investment structure, interest income from the Company's
mortgage loans was a qualified source. The properties that are now owned by
an affiliate of the Company are Senior Housing Facilities that provide
tenants with more services, such as meals, activities, assisted living, etc.,
than are customary for ordinary residential apartment properties. As a
result, a significant portion of the rents paid by the tenants includes
income for the increased level of services received by them. Consequently,
the rents paid by the tenants likely would not be qualified rents for REIT
qualification purposes if received directly by the Company. Therefore, if the
Company received such rents directly, it could lose REIT status and be taxed
as a regular corporation. After extensive review, the Board of Directors
determined that it would be in the best interests of the shareholders for the
Company to retain REIT status and master lease the properties to a
shareholder-owned operating company. As discussed further in Note 4, on
September 12, 1994 the Company formed a new subsidiary, ILM II Lease
Corporation, for the purpose of operating the Senior Housing Facilities. The
Senior Housing Facilities were leased to ILM II Lease Corporation effective
September 1, 1995 (see Note 4 for a description of the master lease
agreement).

The assumption of ownership of the properties through ILM II Holding, which
is presently a regular C corporation for tax purposes, has resulted in a
possible future tax liability which would be payable upon the ultimate sale
of the properties (the "built-in gain tax"). The amount of such tax would be
calculated based on the lesser of the total net gain realized from the sale
transaction or the portion of the net gain realized upon a final sale which
is attributable to the period during which the properties were held by in a C
corporation. The final phase of the Company's restructuring plans involves
the conversion of ILM II Holding to a REIT for tax purposes. Certain changes
to the ownership structure of ILM II Holding which are necessary in order for
ILM II Holding to qualify as a REIT under the Internal Revenue Code are
expected to be made in time for ILM II Holding to elect REIT status in
conjunction with the filing of its calendar 1996 federal tax return. Any
future appreciation in the value of the Senior Housing Facilities subsequent
to the conversion of ILM II Holding to a REIT would not be subject to the
built-in gain tax. The built-in gain tax would most likely not be incurred if
the properties were to be held for a period of at least 10 years from the
date of the conversion of ILM II Holding to a REIT. However, since the end of
the Company's original anticipated holding period is less than 5 years away,
the properties are not expected to be held for an additional 10 years. The
Board of Directors may defer the Company's scheduled liquidation date, if in
the opinion of a majority of the Directors, the disposition of the Company's
assets at such time would result in a material under-realization of the value
of such assets; provided, however, that no such deferral may extend beyond
December 31, 2005. Based on management's current estimate of the increase in
the values of the properties which has occurred since April 1994, as
supported by independent appraisals, ILM II Holding would incur a sizable tax
if the properties were sold. Based on these current estimated market values
of the operating investment properties, a sale at such values prior to the
end of the 10-year holding period could result in a built-in gain tax of as
much as $2.3 million. As the holder of a 99% economic interest in ILM II
Holding, the burden of this built-in gain tax would be primarily borne by the
Company.

F-9

<PAGE>

The Company's affiliate, ILM II Holding, has incurred losses for tax purposes
since inception. Neither the Company nor ILM II Holding is likely to be able
to use these losses to offset future tax liabilities. Accordingly, no income
tax benefit is reflected in these consolidated financial statements.

The Company reports on a calendar year basis for income tax purposes. During
calendar 1995, the Company distributed $0.45 per share in cash and $0.14 per
share in shares of ILM II Lease Corporation. The tax status of these
dividends amounted to an ordinary taxable dividend of approximately $0.41 per
share and a tax free return of capital of approximately $0.18 per share. The
Company anticipates that all distributions during calendar 1996 will be
ordinary taxable dividends.

C. CASH AND CASH EQUIVALENTS

For purposes of reporting cash flows, cash and cash equivalents include all
highly liquid investments with original maturities of 90 days or less.

D. OFFERING COSTS

Offering costs consist primarily of selling commissions and other costs such
as printing and mailing costs, legal fees, filing fees and other marketing
costs associated with the offering of shares. Selling commissions were equal
to 8% of the gross proceeds raised through the public offering. Commissions
totaling $4,120,000 were paid to PWI in connection with the sale of shares.
All of the offering costs are shown as a reduction of shareholders' equity.

E. FAIR VALUE DISCLOSURES

FASB Statement No. 107, "Disclosures about Fair Value of Financial
Instruments" ("SFAS 107"), requires disclosure of fair value information
about financial instruments, whether or not recognized in the balance sheet,
for which it is practicable to estimate that value. In cases where quoted
market prices are not available, fair values are based on estimates using
present value or other valuation techniques. SFAS 107 excludes certain
financial instruments and all non-financial instruments from its disclosure
requirements. Accordingly, the aggregate fair value amounts presented do not
represent the underlying value of the Company.

The following methods and assumptions were used by the Company in estimating
its fair value disclosures for financial instruments:

Cash and cash equivalents: The carrying amount reported on the balance sheet
for cash and cash equivalents approximates its fair value due to the
short-term maturities of such instruments.

Accounts receivable - affiliates: The carrying amount reported on the balance
sheet for accounts receivable affiliates approximates its fair value due to
the short-term maturity of such instrument.

Accounts payable - affiliates: The carrying amount reported on the balance
sheet for accounts payable affiliates approximates its fair value due to the
short-term maturity of such instrument.

4. The Advisory Agreement and Related Party Transactions

Subject to the supervision of the Company's Board of Directors, the business of
the Company is managed by PaineWebber ILM Advisor, L.P. (the "Advisor"), a
limited partnership comprised of ILM REIT Advisor, Inc., a Virginia corporation,
and Properties Associates, L.P. ("PA"), a Virginia limited partnership. ILM REIT
Advisor, Inc. is a wholly owned subsidiary of PaineWebber Properties
Incorporated ("PWPI"). In addition, the limited partners and holders of assignee
interest of PA are or have been officers of PWPI. PWPI is a wholly owned
subsidiary of PaineWebber Incorporated ("PWI"). PWI is a wholly owned subsidiary
of PaineWebber Group, Inc. ("PaineWebber").

F-10

<PAGE>

The Advisor and its affiliates receive fees and compensation determined on an
agreed-upon basis, in consideration of various services performed in connection
with the sale of the shares, the management of the Company and the acquisition,
management and disposition of the Company's investments. The type of
compensation to be paid by the Company to the Advisor and its affiliates under
the terms of the Advisory Agreement is as follows:

1. Under the Advisory Agreement, the Advisor has specific management
responsibilities; to perform day-to-day operations of the Company and to
act as the investment advisor and consultant for the Company in
connection with general policy and investment decisions. The Advisor
will receive an annual Base Fee and an Incentive Fee of 0.25% and 0.25%,
respectively, of the capital contributions of the Company, as defined,
as compensation for such services. Incentive Fees are subordinated to
shareholders' receipt of distributions of net cash sufficient to provide
a return equal to 10% per annum. The Advisor earned base management fees
totaling $130,000 for each of the years ended August 31, 1996, 1995 and
1994. Payment of incentive management fees was suspended effective April
15, 1993 in conjunction with a reduction in the Company's quarterly
dividend payments.

2. For its services in finding and recommending investments, PWPI received
mortgage placement fees equal to 2% of the capital contributions.
Mortgage placement fees totaling $1,036,000 were earned by PWPI during
the Company's investment acquisition period. Such fees have been
capitalized and are included in the cost of the operating investment
properties on the accompanying consolidated balance sheets.

3. For its administrative services with respect to all loans, PWPI
received, directly from AHC, construction loan administration or due
diligence fees equal to 1% of the loan amounts. Loan administration and
due diligence fees totaling $425,141 were earned by PWPI during the
Company's investment due diligence period.

4. The Advisor will be entitled to receive 1% of Disposition Proceeds, as
defined, until the shareholders have received dividends of Net Cash
equal to their Adjusted Capital Investments, as defined, plus a 12%
non-compounded annual return on their Adjusted Capital Investments; all
Disposition Proceeds thereafter until the Advisor has received an
aggregate of 5% of Disposition Proceeds; and, thereafter, 5% of
Disposition Proceeds.

The Advisor and its affiliates are reimbursed for their direct expenses relating
to the offering of Shares, the administration of the Company and the acquisition
and operations of the Company's real estate investments. Included in general and
administrative expenses on the accompanying statements of income for the years
ended August 31, 1996, 1995 and 1994 is $107,000, $121,000 and $133,000,
respectively, representing reimbursements to an affiliate of the Advisor for
providing certain financial, accounting and investor communication services to
the Company.

Mitchell Hutchins Institutional Investors, Inc. ("Mitchell Hutchins") provides
cash management services with respect to the Company's cash assets. Mitchell
Hutchins is a subsidiary of Mitchell Hutchins Asset Management, Inc., an
independently operated subsidiary of PaineWebber. Mitchell Hutchins earned
$6,000, $3,000 and $8000 (included in general and administrative expenses) for
managing the Company's cash assets during fiscal 1996, 1995 and 1994,
respectively.

F-11

<PAGE>

Accounts receivable - affiliates at August 31, 1995 consists primarily of
amounts due from an affiliated company for disbursements made by the Company on
behalf of its affiliate related to the Villa Santa Barbara Facility, which is
jointly owned.

Accounts payable - affiliates at August 31, 1996 consists of management fees of
$32,000 owed to the Advisor for the quarter ended August 31, 1996. Accounts
payable - affiliates at August 31, 1995 includes management fees of $32,000 owed
to the Advisor for the quarter ended August 31, 1995 and $25,000 payable to an
affiliate of PWPI for providing advisory services to ILM II Holding.

5. Investment in ILM II Holding, Inc.

The Company had made certain mortgage loans (collectively, "the Loans") to
Angeles Housing Concepts, Inc. ("AHC"), a company specializing in the
development, acquisition and operation of Senior Housing Facilities. The Company
entered into an Exclusivity Agreement with AHC and its parent company, Angeles
Corporation ("Angeles"), which required AHC to provide the Company with certain
specific opportunities to finance Senior Housing Facilities and set forth the
terms and conditions of the loans which were made. The Company's loans were
secured by first mortgages on the Senior Housing Facilities and a security
interest in all tangible personal property. During the quarter ended February
28, 1993, Angeles announced that it was experiencing liquidity problems that had
resulted in the inability to meet its obligations. Subsequent to such
announcements, AHC defaulted on the regularly scheduled mortgage loan payments
due to the Company on March 1, 1993. Subsequent to March 1993, payments toward
the debt service owed on the Company's loans were limited to the net cash flow
of the operating investment properties. On May 3, 1993, Angeles filed for
reorganization under a Chapter 11 Federal Bankruptcy petition filed in the state
of California. AHC did not file for reorganization. During fiscal 1993 and
continuing in fiscal 1994, the Company retained special counsel and had
extensive discussions with AHC concerning the default status of its loans.
During the fourth quarter of fiscal 1993, a non-binding settlement agreement
between the Company, AHC and Angeles was reached whereby title to ownership of
the properties would be transferred from AHC to the Company.

On April 27, 1994, each of the properties owned by AHC and securing the Loans
was transferred (collectively, "the Transfers") to newly-created special purpose
corporations affiliated with the Company (collectively, "the Property
Companies"). The Transfers had an effective date of April 1, 1994. The Transfers
were made pursuant to the Settlement Agreement entered into on February 17, 1994
("the Settlement Agreement") between the Company and AHC, and previously
approved by the bankruptcy court handling the bankruptcy case of Angeles.
Conveyance documents relating to the Transfers were placed in escrow on February
17, 1994 pending the completion of certain due diligence procedures. This due
diligence process included the setting up of appropriate entities to take title
to the individual properties as well as the completion of the licensing
requirements for each facility. On April 27, 1994, the due diligence process was
completed, escrow was broken and the Transfers were effected. Under the terms of
the Settlement Agreement, the Company released AHC and Angeles from certain
obligations under the Loans.

All of the capital stock of each Property Company is held by ILM II Holding,
Inc. ("ILM II Holding"), a Virginia corporation. The capital stock of ILM II
Holding is owned by the Company and PWP Holding, Inc. ("PWP Holding"), a
wholly-owned subsidiary of PWPI. The Company holds substantially all of the
economic ownership in ILM II Holding, while PWP Holding holds voting control.
ILM II Holding has issued 100 shares of Series A Preferred Stock to the Company
in return for a capital contribution in the amount of $495,000. The holders of
the Series A Preferred Stock are entitled to one vote for each share of
Preferred Stock held. In addition, the holders of the Series A Preferred Stock
are entitled to receive, when and if declared by the Board of Directors,
dividends and distributions in an amount per share equal to the product of 0.1
and 99% of the total amount of dividends and distributions made to all
shareholders. ILM II Holding has also issued 10,000 shares of Common Stock to
PWP Holding in return for a capital contribution in the amount of $5,000. The
holders of the Common Stock are entitled to one vote for each share of Common
Stock held. The holders of the Common Stock are entitled to receive, when and if
declared by the Board of Directors, dividends and distributions in an amount per
share equal to the product of 0.001 and 1% of the total amount of dividends and
distributions made to all shareholders.

Each Property Company acquired the respective operating property subject to, and
assumed the obligations under, the Loan payable to the Company. The principal
balance of each Loan was modified to reflect the estimated fair value of the
related

F-12

<PAGE>

operating property as of the date of the Transfers. The modified Loans require
interest-only payments on a monthly basis at a rate of 7% from April 1, 1994
through December 31, 1994, 9% for the period January 1 through December 31,
1995, 11% for the period January 1 through December 31, 1996, 12% for the period
January 1 through December 31, 1997, 13% for the period January 1 through
December 31, 1998, 13.5% for the period January 1 through December 31, 1999 and
14% for the period January 1, 2000 through maturity, on December 31, 2000.

Management expects the property ownership structure described above to be in
place only temporarily. Since the time that the Company reached agreement with
AHC regarding the terms of the Settlement Agreement, management has been
investigating and evaluating the available options for structuring the ownership
of the properties in order to maximize the potential returns to the existing
shareholders while maintaining the Company's qualification as a Real Estate
Investment Trust ("REIT") under the Internal Revenue Code. The Board of
Directors has identified what it believes is the best structure to accomplish
these objectives, and the Company is in the process of implementing that
structure as of the date of this report.

Certain changes to the presentation of the Company's financial position and
results of operations will be required once the aforementioned permanent
property ownership structure is effected. The Transfers of the Senior Housing
Facilities from AHC to the Property Companies in fiscal 1994 resulted in no gain
or loss recognition by the Company for financial reporting purposes. As stated
above, under generally accepted accounting principles, the Company has always
accounted for its investments in acquisition and construction loans under the
equity method, as if such investments were equity interests in a joint venture.
Accordingly, the carrying values of such investments have been reduced since
inception by non-cash depreciation charges and by payments from AHC, prior to
the default in fiscal 1993, in excess of the net cash flow generated by the
Senior Housing Facilities received pursuant to the guaranty agreement between
the Company and AHC. As a result of this accounting treatment, the carrying
values of the Company's investments had been reduced below management's estimate
of the fair market value of the Senior Housing Facilities as of the effective
date of the Transfers. Accordingly, for financial reporting purposes the Company
has continued to employ its historical cost basis in accounting for these
investments subsequent to the Transfers and has continued to record its share of
the operating results of the properties in its statement of income. For federal
income tax purposes, the investments have always been carried at the
contractually stated principal balances of the Loans. For tax purposes only, a
loss will be recognized by the Company in 1994 in the amount by which the stated
principal balances of the Loans were reduced as of the date of the Transfers
(see discussion below).

Based on the initial economic structure of the loan transactions and the
expected future allocations of cash flows between the Company and AHC,
management originally estimated that the Company's allocable share of the
earnings or losses of the properties securing the loan investments was
approximately 90% of the total earnings or losses (including depreciation
expense) of such properties. As a result of the loan defaults and the Settlement
Agreement discussed further above, management believes that the initial economic
structure of the Company's investments has changed and, accordingly, the Company
has recognized 100% of the earnings or losses of the underlying operating
properties in the accompanying statement of income for fiscal 1996, 1995 and
1994 and are reported within Investment in and construction loans to ILM II
Holding, Inc. on the accompanying balance sheet.

F-13

<PAGE>

The following mortgage loans were outstanding at August 31, 1996 and 1995.

Property
Pledged Face Amount Date of
as Collateral 8/31/96 8/31/95 Loans
- ------------ ------- ------- -----

The Palms $8,700,000 $8,700,000 7/18/90
Fort Myers, FL

Crown Villa 4,950,000 4,950,000 4/25/91
Omaha, NE

Overland Park Place 7,850,000 7,850,000 4/9/92
Overland Park, KS

Rio Las Palmas 5,700,000 5,700,000 5/14/92
Stockton, CA

The Villa at Riverwood 5,850,000 5,850,000 5/29/92
St. Louis

Villa Santa Barbara 5,094,000 4,774,000 7/13/92

Santa Barbara, CA
------------ --------------
$38,144,000 $37,824,000
Less discount (4,138,000) (4,138,000)
------------ --------------
$34,006,000 $33,686,000
============ ==============

A discount was recorded on the long-term debt in the amount by which the
modified principal amount of the loans exceeded the historical cost basis of the
properties at the time of the Transfers.

Descriptions of the properties financed by the Company's loans are summarized
below:

The Palms, Fort Myers, Florida
------------------------------

In July 1990, the Company acquired a loan with respect to an existing
204-unit Senior Housing Facility known as The Palms, located in Fort
Myers, Florida. Construction of the Senior Housing Facility, which was
99% leased as of August 31, 1996, was completed in October 1988.

F-14

<PAGE>

Crown Villa, Omaha, Nebraska
----------------------------

In April 1991, the Company acquired a loan with respect to a recently
completed 73-unit Senior Housing Facility known as Crown Villa, located in
Omaha, Nebraska. Construction of the Senior Housing Facility was completed
in January 1992. As of August 31, 1996, the project was 99% leased.

Overland Park Place, Overland Park, Kansas
------------------------------------------

In April 1992, the Company acquired a loan with respect to an existing
137-unit Senior Housing Facility known as Overland Park Place, located in
Overland Park, Kansas. Construction of the Senior Housing Facility was
completed in June 1984. As of August 31, 1996, the project was 91%leased.

Rio Las Palmas, Stockton, California
------------------------------------

In May 1992, the Company acquired a loan with respect to an existing
162-unit Senior Housing Facility known as Rio Las Palmas, located in
Stockton, California. Construction of the Senior Housing Facility was
completed in June 1988. As of August 31, 1996, the project was 90% leased.

The Villa at Riverwood, St. Louis County, Missouri
--------------------------------------------------

In May 1992, the Company acquired a loan with respect to an existing
119-unit Senior Housing Facility known as The Villa at Riverwood, located
in St. Louis County, Missouri. Construction of the Senior Housing Facility
was completed in June 1985. As of August 31, 1996, the project was 94%
leased.

Villa Santa Barbara, Santa Barbara, California
----------------------------------------------

In July 1992, the Company acquired a loan with respect to an existing
123-unit Senior Housing Facility known as Villa Santa Barbara, located in
Santa Barbara, California. The acquisition and improvement of the facility
was financed by the aforementioned loan and another loan from an affiliated
company, PaineWebber Independent Living Mortgage Fund, Inc. (ILM I). Any
amounts due from Angeles Housing with regard to the mortgage loans on the
Santa Barbara property will be equitably apportioned between the Company
and ILM I (generally 75% to the Company and 25% to ILM I). The Company and
ILM I have entered into an Intercreditor Agreement to set forth their
respective rights and entitlements under the loan documents. Construction
of the Senior Housing Facility was completed in 1979. As of August 31,
1996, the project was 81% leased.

Other Information Regarding Mortgage Loans:

The Settlement Agreement calls for AHC to be retained in a property management
capacity under a contract covering the operating properties (the "Management
Contract"). The terms of the Management Contract provide that AHC will receive a
base management fee (the "Base Management Fee") equal to 5.5% of Gross Operating
Revenues, as defined. In addition, AHC is eligible to earn additional
compensation through a 25% participation in excess cash flow or sale or
refinancing proceeds above specified levels. The thresholds at which AHC would
begin to participate in excess cash flow or sale or refinancing proceeds have
been set at levels which provide that the Company would receive all amounts to
which it was originally entitled under the terms of the Exclusivity Agreement on
a cumulative basis before such participation begins. The Property Companies have
the right to terminate the Management Contract for cause at any time and can
terminate the agreement without cause upon 30 days' written notice to AHC. The
Property Companies can also terminate the Management Contract immediately if
certain current executive officers of AHC do not remain in their present
capacities. Furthermore, the Property Companies have the option of terminating
the Management Contract any time after December 31, 1994 by giving 30 days'
written notice following any fiscal quarter for which the net operating income
level of each operating property fails to equal or exceed certain specified
levels. If the Management Contract were terminated on or before June 30, 1995,
either without cause or because the specified executive officers failed to
remain employed by AHC, AHC would be entitled to receive a termination fee equal
to 24 months Base Management Fee calculated based on annualized Gross Operating
Revenue for the three calendar months immediately preceding such termination.
Under these circumstances the termination fee declines to 18 months Base
Management Fee after June 30, 1995 and to 12 months Base

F-15

<PAGE>

Management Fee after June 30, 1996. If the Management Contract is terminated
because the net operating income levels are below the specified amounts, the
termination fees described above would be subject to reduction to between 75%
and 0% of the applicable amount depending on the magnitude of the net income
shortfall. The Company has guaranteed payment of the termination fee.

Condensed balance sheets of ILM II Holding, Inc. as of August 31, 1996 and 1995
are presented as follows:

Assets
------
August 31, 1996 August 31, 1995
--------------- ---------------

Current Assets $ 634
$ 1,052
Operating Investment Properties, net 31,940 32,964
------- ----------
$32,574 $ 34,016
======= =========

Liabilities and Shareholders' Equity
------------------------------------

Current liabilities $ 3 $ 584
Long term debt 34,006 33,686
Shareholders' equity (1,435) (254)
-------- ----------
$ 32,574 $ 34,016
======== ==========

Reconciliation of Company's Investment
--------------------------------------

Company's share of capital at August 31, 1996 $ (1,435)
Excess basis due to investment in and
construction loans to ILM Holding, Inc. (1) 550
Company's share of investee's current liabilities
and long-term debt 34,006
Permanent difference due to settlement of claims
with Angeles Corporation and affiliates (2) (948)
============
Investment in and construction loans to ILM
Holding, Inc. $ 32,173
============

(1) The Company's investment in and construction loans to ILM Holding, Inc.
includes amounts representing acquisition fees and other expenses incurred
by the Company in connection with the acquisition of the construction loans
encumbering the ILM Holding, Inc. properties. Excess basis is being
amortized over the term of the loans.

(2) As described in Note 5 under Angeles Corporation Litigation. Summarized
operations of the investment properties securing the Company's mortgage
loans for the year ended August 31, 1996, the two months ended August 31,
1995, and the years ended June 30, 1995 and 1994 are as follows:

F-16

<PAGE>

Condensed Summary of Operations
-------------------------------

Year ended Two months ended Year ended Year ended
August 31, 1996 August 31, 1995 June 30, 1995 June 1994
--------------- ---------------- ------------- ----------
<S> <C> <C> <C> <C>

Revenues $ 4,017 $ 2,036 $ 11,794 $ 10,865

Operating Expenses -- 1,406 8,114 7,660
Depreciation expense 1,127 196 1,170 1,105
Interest expense 3,998 518 3,033 4,965
Management fees -- 10 59
General and administrative 73 -- -- --
-------- -------- -------- --------

Net loss $ (1,181) $ (94) $ (582) $ (2,865)
======== ======== ======== ========

Company's share of loss $ (1,181) $ (94) $ (582) $ (2,865)
Borrowers' share of income -- -- -- --
-------- -------- -------- --------
$ (1,181) $ (94) $ (582) $ (2,865)
======== ======== ======== ========

Reconciliation of Company's Share of Income

Net loss $ (1,181) $ (94) $ (582) $ (2,865)
======== ========= ========= ========
Interest on mortgage loans issued
by the Company 3,998 518 3,033 4,965
Amortization of excess basis (143) -- (143) (143)
-------- -------- -------- --------
Equity in income of ILM II Holding $ 2,674 $ 424 $ 2,308 $ 1,957
======== ======== ======== ========

</TABLE>

As discussed earlier, on September 12, 1994 the Company formed a new subsidiary,
ILM II Lease Corporation, for the purpose of operating the Senior Housing
Facilities. The Senior Housing Facilities were leased to ILM II Lease
Corporation effective September 1, 1995 (see Item 7 for a description of the
master lease agreement). A condensed balances sheet as of August 31, 1996 and
summary of operations for the year then ended of ILM II Lease Corporation are as
follows:

Assets
------
August 31, 1996
---------------

Current Assets $1,714
Furniture, fixtures and equipment 183
Other non-current assets 38
------
$1,935
======

Liabilities and Shareholders' Equity
------------------------------------

Current liabilities $1,045
Other non-current liabilities 131
Shareholders' equity 759
------
$1,935
======

F-17

<PAGE>

Summary of Operations
---------------------
Year ended
August 31, 1996
---------------

Revenues $13,201

Operating expenses 12,768
Income tax expense 173
-------
Net income $ 260
=======

6. Legal Proceedings and Contingencies

Angeles Corporation Litigation

Angeles had guaranteed certain of the obligations of AHC under the terms of the
Exclusivity Agreement described in Note 1. Under the terms of the Settlement
Agreement discussed in Note 1, the Company retained a general unsecured claim
against Angeles in the amount of $1,200,658 as part of the bankruptcy
proceedings, but waived all other claims against Angeles, including any amounts
of base and additional interest owed. In addition, the Company maintained a
claim for approximately $408,000 against an affiliate of Angeles which had made
a separate guaranty to the Company. On March 17, 1995, the Bankruptcy Court
handling the Angeles bankruptcy proceedings approved a final settlement of the
Company's outstanding claims against Angeles and its affiliates. Pursuant to the
terms of this settlement, the Company received a cash payment of $1 million on
April 14, 1995 in full satisfaction of the claims, which totaled approximately
$1.6 million. This amount, net of certain related legal expenses, was recorded
as a reduction in the carrying values of the Company's operating investment
properties.

Termination of Management Contract with AHC

On July 29, 1996, ILM II Lease Corporation and ILM II Holding, Inc. ("the
Companies") terminated the property management agreement with AHC covering the
six senior housing facilities leased by ILM II Lease Corporation from ILM
Holding, the Company's consolidated affiliate. The management agreement was
terminated for cause pursuant to Sections 1.05 (a) (i), (iii) and (iv) of the
agreement. Simultaneously with the termination of the management agreement, the
Companies, together with certain affiliated entities, filed suit against AHC in
the United States District Court for the Eastern District of Virginia for breach
of contract, breach of fiduciary duty and fraud. ILM II Lease Corporation and
ILM II Holding allege that AHC willfully performed actions specifically in
violation of the management agreement and that such actions caused damages to
the Companies. Due to the termination of the agreement for cause, no termination
fee was paid to AHC. Subsequent to the termination of the management agreement,
AHC filed for protection under Chapter 11 of the U.S. Bankruptcy Code in its
domestic state of California. The filing was challenged by the Companies, and
the Bankruptcy Court dismissed AHC's case effective October 15, 1996. In
November 1996, AHC filed with the Virginia District Court an Answer in response
to the litigation initiated by the Companies and a Counterclaim against ILM II
Holding. The Counterclaim alleges that the management agreement was wrongfully
terminated for cause and requests damages which include the payment of the
termination fee in the amount of $750,000, payment of management fees pursuant
to the contract from August 1, 1996 through October 15, 1996, which is the
earliest date that the management agreement could have been terminated without
cause, and recovery of attorney's fees and expenses. In the event ILM II Lease
Corporation cannot perform its obligation to pay such amounts, PaineWebber
Independent Living Mortgage Inc. II guaranteed the payment of any termination
fee the court deems to be owed as a result of these proceedings; however,
management believes that ILM II Lease Corporation has the ability to perform
under the terms of the management agreement in the event of an unfavorable
outcome to this litigation and that the probability of PaineWebber Independent
Living Mortgage Inc. II incurring a loss under the terms of its guaranty is
remote. The Companies intend to diligently prosecute the case and to vigorously
defend the counterclaims

F-18

<PAGE>

made by AHC. The eventual outcome of this termination dispute cannot presently
be determined. Accordingly, no provision for any liability which might result
from the Company's guaranty of the termination fee has been recorded in the
accompanying financial statements.

ILM II Lease Corporation has retained Capital Senior Management 2, Inc.
("Capital") of Dallas, Texas to be the new manager of the senior housing
facilities pursuant to a Management Agreement which commenced on July 29, 1996.
Under the terms of the Agreement, Capital will earn a Base Management Fee equal
to 4% of the Gross Operating Revenues of the senior housing facilities, as
defined. Capital will also be eligible to earn an Incentive Management Fee equal
to 25% of the amount by which the average monthly Net Cash Flow of the senior
housing facilities, as defined, for the twelve month period ending on the last
day of each calendar month exceeds a specified Base Amount. Each August 31,
beginning on August 31, 1997, the Base Amount will be increased annually based
on the percentage increase in the Consumer Price Index. PaineWebber Independent
Living Mortgage Inc. II has guaranteed the payment of all fees due to Capital
under the terms of the Management Agreement.

Effective in November 1996, Lawrence A. Cohen, President, Chief Executive
Officer and Director of the Company, was also named Vice Chairman and Chief
Financial Officer of Capital Senior Living Corporation, an affiliate of Capital.

Shareholder Matters

F-19

<PAGE>

In February 1996, approximately 150 plaintiffs filed an action entitled Abbate
v. PaineWebber Inc. in Sacramento, California Superior Court against PaineWebber
Incorporated and various affiliated entities concerning the plaintiffs'
purchases of various limited partnership investments and REIT stocks, including
those offered by the Company. The complaint alleges, among other things, that
PaineWebber and its related entities committed fraud and misrepresentation and
breached fiduciary duties allegedly owed to the plaintiffs by selling or
promoting limited partnership and REIT investments that were unsuitable for the
plaintiffs and by overstating the benefits, understating the risks and failing
to state material facts concerning the investments. The complaint seeks
compensatory damages of $15 million plus punitive damages. In September 1996,
the court dismissed many of the plaintiffs' claims as barred by applicable
securities arbitration regulations.

With respect to the Abbate, Bandrowski and Barstad actions described above, the
defendants' time to move against or answer the complaints has not yet expired.
In all cases, PaineWebber intends to vigorously contest the allegations of the
actions. However, the eventual outcome of this litigation and the potential
impact, if any, on the Company's shareholders cannot be determined at the
present time. Mediation hearings on the Abbate, Bandrowski and Barstad actions
are currently scheduled to be held in December 1996.

Under certain limited circumstances, pursuant to the Advisor Agreement with the
Advisor and other contractual obligations, PaineWebber affiliates could be
entitled to indemnification for expenses and liabilities in connection with the
shareholder litigation matters described above. However, PaineWebber has agreed
not to seek indemnification for any amounts it is required to pay in connection
with the settlement of the New York Limited Partnership Actions. At the present
time, neither PaineWebber nor management can estimate the impact, if any, of any
of the potential indemnification claims on the Company's financial statements,
taken as a whole. Accordingly, no provision for any liability which could result
from the eventual outcome of these matters has been made in the accompanying
financial statements.

7. Subsequent Events

On September 15, 1996, the Company's Board of Directors declared a quarterly
dividend for the quarter ended August 31, 1996. On October 14, 1996, a dividend
of $0.125 per share of common stock, totaling $648,000, was made to Shareholders
of record as of September 30, 1996. On December 13, 1996, the Board of Directors
declared a quarterly dividend for the quarter ended November 30, 1996. On
January 15, 1997, a dividend of $0.1625 per share of common stock, totaling
$842,000, will be made to shareholders of record as of January 2, 1997.

8. Events (unaudited) Subsequent to December 10, 1996

F-20

<PAGE>

common stock and 275 shares of a new class of nonvoting, 8% cumulative preferred
stock issued to the Company. The number of authorized shares of preferred and
common stock in ILM II Holding were also increased as part of the
recapitalization. Following the recapitalization, the Company made charitable
gifts of one share of the preferred stock in ILM II Holding to each of 111
charitable organizations so that ILM II Holding would meet the stock ownership
requirements of a REIT as of January 30, 1997. The preferred stock has a
Liquidation Preference of $1,000 per share plus any accrued and unpaid
dividends. Dividends on the preferred stock will accrue at a rate of 8% per
annum on the original $1,000 Liquidation Preference and will be cumulative from
the date of issuance. Since ILM II Holding is not expected to have sufficient
cash flow in the foreseeable future to make the required dividend payments, it
is anticipated that dividends will accrue and be paid at liquidation.

With regard to the litigation described in Note 5 under "Termination of
Management Contract with AHC," the court initially set a trial date of April 28,
1997 but, at AHC's request, recently rescheduled the trial for June 23, 1997. On
June 13, 1997 and July 8, 1997, the court issued Orders purporting to enter
judgment against the Company and ILM I in the amount of $1,000,000. In so doing,
the court effectively canceled the June 23, 1997 trial date. The Orders do not
contain any findings of fact or conclusions of law. On July 10, 1997, the
Company, ILM I, ILM I Lease Corporation and ILM II Lease Corporation filed a
notice of appeal to the United State Court of Appeals for the Fourth Circuit
from the Orders. The Company intends to diligently prosecute the appeal. The
eventual outcome of this litigation cannot presently be determined. However, as
reported in the Company's report on Form 10-Q for the quarter ended May 31,
1997, the Company has recorded a provision in the amount of $400,000 for the
liability which might result from the court's Orders.

On February 4, 1997, AHC filed a Complaint in the Superior Court of the State of
California against Capital, Lawrence Cohen, President, Chief Executive Officer
and a director of the Company, and others alleging that the defendants
intentionally interfered with AHC's property management agreement. The complaint
seeks damages of at least $2,000,000. On March 4, 1997, the defendants removed
the case to federal district court in the Central District of California. Trial
in the action has been set for January 13, 1998 and discovery has just begun. At
a Board meeting on February 26, 1997, the Company's Board of Directors concluded
that since all of Mr. Cohen's actions relating to the California litigation were
taken either on behalf of the Company under the direction of the Board or as a
PaineWebber Properties employee, the Company or its affiliates should indemnify
Mr. Cohen with respect to any expenses arising from the California litigation,
subject to any insurance recoveries for those expenses. The Company's Board also
concluded that, subject to certain conditions, the Company or its affiliates
should advance up to $20,000 to pay reasonable legal fees and expenses incurred
by Capital in the California litigation. Subsequently, the boards of directors
of ILM I Lease Corporation and ILM II Lease Corporation voted to increase the
maximum amount of the advance to $100,000. The defendants intend to vigorously
defend the claims made against them in the California litigation. The eventual
outcome of this litigation cannot presently be determined and, accordingly, no
provision for any liability has been recorded in the accompanying financial
statements.

With regard to the litigation described in Note 5 under "Shareholder Matters,"
in March 1997, the United States District Court for the Southern District of New
York announced its final approval of the proposed settlement of the New York
Limited Partnership Actions (see the Annual Report for further information). The
release of the agreed upon settlement proceeds had been delayed pending the
resolution of an appeal of the settlement agreement by two of the plaintiff
class members. In July, 1997, the United States Court of Appeals for the Second
Circuit upheld the settlement over the objections of the two class members. As
part of the settlement agreement, PaineWebber has agreed not to seek
indemnification from the related partnerships and real estate investment trusts
at issue in the litigation (including the Company) for any amounts that it is
required to pay under the settlement. In addition, in December 1996 PaineWebber
agreed to settle the Abbate, Bandrowski and Barstad actions discussed further in
the Annual Report. Final releases and dismissals with regard to these actions
were received during fiscal 1997. Based on these settlement agreements which
cover all of the outstanding shareholder litigation, and notwithstanding the
appeal of the class action settlement referred to above, management does not
expect that the resolution of these matters will have a material impact on the
Company's financial statements, taken as a whole.

F-21

<PAGE>

Report of Independent Auditors

The Shareholders of
ILM II Holding, Inc:

We have audited the accompanying balance sheets of ILM II Holding, Inc. (the
"Company"), as of August 31, 1996 and 1995 and the related statements of
operations, changes in shareholders' deficit and cash flows for the year ended
August 31, 1996, the two month period ended August 31, 1995 and the year ended
June 30, 1995. Our audits also included the financial statement schedule listed
in the Index at Item 14(a). These financial statements and schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements and schedule based on our audits.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of ILM II Holding, Inc. at August
31, 1996, and the results of its operations and its cash flows for the year
ended August 31, 1996, the two month period ended August 31, 1995 and the year
ended June 30, 1995 in conformity with generally accepted accounting principles.
Also, in our opinion, the related financial statement schedule, when considered
in relation to the basic financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.

/S/ERNST & YOUNG LLP
ERNST & YOUNG LLP

Boston, Massachusetts
December 10, 1996

F-22

<PAGE>

ILM II HOLDING, INC.

BALANCE SHEETS
August 31, 1996 and 1995
(In thousands, except per share amounts)

Assets
------
1996 1995
-----------------------
<S> <C> <C>
Operating investment properties, at cost:
Land $ 5,030 $ 5,030
Building and improvements 25,714 25,611
Furniture, fixtures and equipment 3,964 3,964
-----------------------
34,708 34,605
Less accumulated depreciation (2,768) (1,641)
-----------------------
31,940 32,964

Cash and cash equivalents 245 811
Accounts receivable -- 13
Accounts receivable - related party 225 188
Deferred rent receivable 131 --
Other assets 33 40
-----------------------
$ 32,574 $ 34,016
=======================

Liabilities & Shareholders' Deficit
-----------------------------------
Mortgages payable $ 34,006 $ 33,686
Accounts payable - related party -- 83
Accounts payable and accrued expenses 3 501
-----------------------
Total liabilities 34,009 34,270

Shareholders' deficit
Preferred stock (Series A, $1 par value, 100 shares
authorized, issued and outstanding) 1 1
Common stock ($1 par value, 10,000 shares
authorized, issued and outstanding) 10 10
Additional paid-in capital 489 489
Accumulated deficit (1,935) (754)
-----------------------
Total shareholders' deficit (1,435) (254)
-----------------------
$ 32,574 $ 34,016
=======================
</TABLE>

See accompanying notes.

F-23

<PAGE>

ILM II HOLDING, INC.

STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)

Expenses:
Property operating -- 1,406 8,114
Depreciation 1,127 196 1,170
Interest 3,998 518 3,033
Management advisory fees -- 10 59
General and administrative 73 -- --
--------------------------------------------------
5,198 2,130 12,376
--------------------------------------------------

Net loss (1,181) (94) (582)
==================================================

Loss per share of
common stock $(118.10) $ (9.40) $ (58.20)
==================================================

</TABLE>

See accompanying notes.

F-24

<PAGE>

ILM II HOLDING, INC.

STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (DEFICIT)
For the year ended August 31, 1996, the two month period ended
August 31, 1995 and the year ended June 30, 1995
(In thousands, except per
share amounts)

Common Stock Preferred Stock
$.01 Par Value $.01 Par Value Additional
------------------- ---------------- Paid-in Accumulated
Shares Amount Shares Amount Capital Deficit Total
------ ------ ------ ------ ------------ ------------ -----------
<S> <C> <C> <C> <C> <C> <C> <C>

Shareholders' equity
at June 30, 1994 10,000 $10 100 $1 $ 489 $ (78) $ 422

Net loss -- -- -- -- -- (582) (582)
------- ------- ------- ------- ------- ------- -------
Shareholders' equity
at June 30, 1995 10,000 10 100 1 489 (660) (160)

Net loss -- -- -- -- -- (94) (94)
------- ------- ------- ------- ------- ------- -------
Shareholders' equity
at August 31, 1995 10,000 10 100 1 489 (754) (254)

Net loss -- -- -- -- -- (1,181) (1,181)
------- ------- ------- ------- ------- ------- -------
Shareholders' deficit
at August 31, 1996 10,000 $10 100 $1 $489 $(1,935) $(1,435)
======= ======= ======= ======= ======= ======= =======

</TABLE>

See accompanying notes.

F-25

<PAGE>

ILM II HOLDING, INC.

STATEMENTS OF CASH FLOWS
(In thousands)

For the two month
For the year ended period ended For the year ended
August 31, 1996 August 31, 1995 June 30, 1995
------------------------------------------------------------
<S> <C> <C> <C>
Operating activities:
Net loss $(1,181) $(94) $(582)
Adjustments to reconcile net income to net
cash used for operating activities:
Depreciation 1,127 196 1,170
Changes in operating assets and liabilities:
Accounts receivable 13 17 (30)
Accounts receivable - related party (37) 33 663
Other assets 7 27 89
Deferred rent receivable (131) -- --
Accounts payable - related party (83) -- --
Accounts payable and accrued expenses (498) (235) (360)
-------------------------------------------
Total adjustments 398 38 1,532
-------------------------------------------
Net cash used in operating activities (783) (56) 950
-------------------------------------------
Investing activities:
Additions to operating investment properties (103) (139) (1,189)
-------------------------------------------
Net cash used for investing activities (103) (139) (1,189)
-------------------------------------------

Financing activities:
Advances under mortgage notes 320 64 523
-------------------------------------------
Net cash provided by financing activities 320 64 523
-------------------------------------------

Net decrease in cash and cash equivalents
at end of period (566) (131) 284
Cash and cash equivalents at beginning of year 811 942 658
-------------------------------------------
Cash and cash equivalents at end of year 245 811 942
===========================================
</TABLE>

See accompanying notes.

F-26

<PAGE>

1. Nature of Operations and Basis of Presentation

PaineWebber Independent Living Mortgage Inc. II ("ILM II") invested in six
participating mortgage loans secured by Senior Housing Facilities located in
five different states. All of the loans made by ILM II were originally with
Angeles Housing Concepts, Inc. ("AHC"), a company specializing in the
development, acquisition and operation of Senior Housing Facilities. ILM II
entered into an Exclusivity Agreement with AHC and its parent company, Angeles
Corporation ("Angeles"), which required AHC to provide ILM II with certain
specific opportunities to finance Senior Housing Facilities and set forth the
terms and conditions of the loans which were made. The loan documents under the
aforementioned Exclusivity Agreement called for interest to be paid on
construction loans at the rate of 13.3% per annum during the construction period
and for Base Interest to be paid on the permanent loans at the rate of 10.3% per
annum. In addition to the Base Interest, Additional Interest was to be payable
on the permanent loans in an amount equal to 10% of the Gross Revenues of the
Senior Housing Facilities, as defined. Under the terms of the amended
Exclusivity Agreement, Additional Interest was to be no less than 3% of the
aggregate principal amount of all permanent loans outstanding for the entire
term of the investments. In the aggregate, the properties securing loans from
ILM II did not generate sufficient cash flow to cover the debt service payments
owed to ILM II under the amended terms of the Exclusivity Agreement. To the
extent that the properties did not generate sufficient cash flow to make the
full payments due under the loan documents, the shortfall was funded by AHC
through December 1992. The source of cash to make up these shortfalls was from
specified deficit reserve accounts, which had been funded from the proceeds of
the mortgage loans, and from contributions by Angeles.

During the quarter ended February 28, 1993, Angeles announced that it was
experiencing liquidity problems that resulted in the inability to meet its
obligations. Subsequent to such announcements, AHC defaulted on the regularly
scheduled mortgage loan payments due to ILM II on March 1, 1993. Subsequent to
March 1993, payments toward the debt service owed on ILM II's loans were limited
to the net cash flow of the operating investment properties. On May 3, 1993,
Angeles filed for reorganization under a Chapter 11 Federal Bankruptcy petition
filed in the state of California. AHC did not file for reorganization. ILM II
retained special counsel and held extensive discussions with AHC concerning the
default status of its loans. During the fourth quarter of fiscal 1993, a
non-binding settlement agreement between ILM II, AHC and Angeles was reached
whereby ownership of the properties would be transferred from AHC to ILM II or
its designated affiliates. Under the terms of the Settlement Agreement, ILM II
released AHC and Angeles from certain obligations under the loans. On April 27,
1994, each of the properties owned by AHC and securing the Loans was transferred
(collectively, "the Transfers") to newly-created special purpose corporations
affiliated with ILM II (collectively, "the Property Companies"). The Transfers
had an effective date of April 1, 1994 and were made pursuant to the Settlement
Agreement entered into on February 17, 1994 ("the Settlement Agreement") between
ILM II and AHC which had previously been approved by the bankruptcy court
handling the bankruptcy case of Angeles. All of the capital stock of each
Property Company was held by ILM II Holding, Inc. (the "Company"), a Virginia
corporation. In August 1995, each of the Property Companies merged into the
Company. As a result, ownership of the Senior Housing Facilities is now held by
the Company, and the Property Companies no longer exist as separate legal
entities. The capital stock of the Company is owned by ILM II and PWP Holding,
Inc. ("PWP Holding"), a wholly-owned subsidiary of PaineWebber Properties
Incorporated ("PWPI"). PWPI is a wholly owned subsidiary of PaineWebber
Incorporated, which is a wholly owned subsidiary of PaineWebber Group, Inc.
("PaineWebber").

As part of the fiscal 1994 settlement agreement with AHC, the Company retained
AHC as the property manager for all of the Senior Housing Facilities pursuant to
the terms of a management agreement. As discussed further in Note 8, the
management agreement with AHC was terminated in July 1996. Subsequent to the
effective date of the Settlement Agreement with AHC, management investigated and
evaluated the available options for structuring the ownership of the properties
in order to maximize the potential returns to the existing shareholders while
maintaining ILM II's qualification as a REIT under the Internal Revenue Code. On
September 12, 1994, ILM II formed a new subsidiary, ILM II Lease Corporation,
for the purpose of operating the Senior Housing Facilities. The Senior Housing
Facilities were leased to ILM II Lease Corporation effective September 1, 1995
(see Note 7 for a description of the master lease agreement).

2. Use of Estimates and Summary of Significant Accounting Policies

The accompanying financial statements have been prepared on the accrual basis of
accounting in accordance with generally accepted accounting principles which
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosures of contingent assets and
liabilities as of August 31, 1996 and 1995 and revenues and expenses for the
year ended August 31, 1996, the two month period ended August 31, 1995, and the
year ended June 30, 1995. Actual results could differ from the estimates and
assumptions used.

F-27
<PAGE>

In 1995, in connection with the restructuring of property ownership described
above, the Company changed its fiscal year end from June 30 to August 31.

The Company's significant accounting policies are summarized as follows:

A. BASIS OF PRESENTATION

The operating cycle in the real estate industry is longer than one year
and the distinction between current and non-current is of little
relevance. Accordingly, the accompanying balance sheets are presented in
an unclassified format.

B. INCOME TAXES

For purposes of filing federal tax returns, the financial statements of
the Company are consolidated with those of ILM II. The Company has
incurred losses for tax purposes since inception. Neither ILM II nor the
Company is likely to be able to use these losses to offset future tax
liabilities. Accordingly, no income tax benefit is reflected in these
financial statements.

C. CASH AND CASH EQUIVALENTS

For purposes of reporting cash flows, cash and cash equivalents include
all highly liquid investments with original maturities of 90 days or
less.

D. FAIR VALUE DISCLOSURES

FASB Statement No. 107, "Disclosures about Fair Value of Financial
Instruments" ("SFAS 107"), requires disclosure of fair value information
about financial instruments, whether or not recognized in the balance
sheet, for which it is practicable to estimate that value. In cases
where quoted market prices are not available, fair values are based on
estimates using present value or other valuation techniques. SFAS 107
excludes certain financial instruments and all non-financial instruments
from its disclosure requirements. Accordingly, the aggregate fair value
amounts presented do not represent the underlying value of the Company.

The following methods and assumptions were used by the Company in
estimating its fair value disclosures for financial instruments:

Cash and cash equivalents: The carrying amount reported on the balance
sheet for cash and cash equivalents approximates its fair value due to
the short-term maturities of such instruments.

Accounts receivable - related party: The carrying amount reported on the
balance sheet for accounts receivable - related party approximates its
fair value due to the short-term maturity of such instrument.

Accounts payable - related party: The carrying amount reported on the
balance sheet for accounts payable related party approximates its fair
value due to the short-term maturity of such instrument.

Mortgages payable: Due to the unique nature of the debt arrangement as
described in Note 5, management is unable to determine the fair value of
mortgages payable without incurring excessive costs.

E. OPERATING INVESTMENT PROPERTIES

Operating investment properties are carried at the lower of cost,
reduced by accumulated depreciation, or net realizable value. The net
realizable value of a property held for long-term investment purposes is
measured by the recoverability of the owner's investment through
expected future cash flows on an undiscounted basis, which may exceed
the property's current market value. The net realizable value of a
property held for sale approximates its current market value as
determined on a discounted basis. None of the operating investment
properties were held for sale as of August 31, 1996 or 1995.
Depreciation expense is provided on a straight-line basis using an
estimated useful life of 40 years for the buildings and improvements and
5 years for the furniture, fixtures and equipment.

F-28
<PAGE>

The Company has reviewed FAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets To Be Disposed Of," which is
effective for financial statements for years beginning after December
15, 1995, and believes this new pronouncement will not have a material
effect on the Company's financial statements.

F. RENTAL REVENUES

In fiscal 1995 rental income consisted of payments due on the individual
tenant leases at the Senior Housing Facilities. Units at the Facilities
are generally rented for terms of twelve months or less. The base rent
charged varies depending on the unit size, with added fees collected for
more than one occupant per unit and for assisted living services.
Included in the amount of base rent charged are certain meals,
housekeeping, medical and social services provided to the residents of
each Facility. In fiscal 1996, rental revenues consist of payments due
from ILM II Lease Corporation under the terms of the master lease
described in Note 7. Base rental income under the master lease is
recognized on a straight-line basis over the term of the lease. Deferred
rent receivable on the balance sheet as of August 31, 1996 represents
the difference between rental income on a straight-line basis and rental
income received under the terms of the master lease

3. The Advisory Agreement and Related Party Transactions

Subject to the supervision of ILM II's Board of Directors, the business of ILM
II and the Company is managed by PaineWebber ILM Advisor, L.P. (the "Advisor"),
a limited partnership comprised of ILM REIT Advisor, Inc., a Virginia
corporation, and Properties Associates, L.P. ("PA"), a Virginia limited
partnership. ILM REIT Advisor, Inc. is a wholly owned subsidiary of PaineWebber
Properties Incorporated ("PWPI"). In addition, the limited partners and holders
of assignee interest of PA are or have been officers of PWPI. PWPI is a wholly
owned subsidiary of PaineWebber Incorporated ("PWI"). PWI is a wholly owned
subsidiary of PaineWebber Group, Inc. ("PaineWebber"). The Advisor and its
affiliates receive fees and compensation determined on an agreed-upon basis, in
consideration of various services performed in connection with the sale of the
shares, the management of ILM II and the acquisition, management and disposition
of ILM II's investments.

Management advisory fees for the two month period ended August 31, 1995 and the
year ended June 30, 1995 were earned by an affiliate of PWPI for its
administration and supervision of the day-to-day operations of the Company. Such
fees were equal to 0.5% of the Gross Operating Revenues of the Senior Housing
Facilities. These management advisory fees were no longer charged to the Company
effective September 1, 1995 upon the commencement of the master lease described
in Note 7. Accounts payable - related party at August 31, 1995 represents the
Company's outstanding liability for these fees at that date.

Accounts receivable - related party at August 31, 1996 represents advances in
the amount of $225,000 made to ILM II Lease Corporation (see Note 7) primarily
for the purchase of personal property to operate the Senior Housing Facilities.
Accounts receivable - related party at August 31, 1995 consists primarily of
amounts receivable from an affiliated company for advances made on behalf of the
affiliated company to the Villa Santa Barbara Senior Housing Facility.

Accounts payable - related party at August 31, 1995 represents amounts due to
the Advisor for management advisory services provided to the Company through
August 31, 1995.

4. Operating Properties

Descriptions of the Company's operating properties are summarized below:

The Palms, Fort Myers, Florida
------------------------------

In July 1990, ILM II acquired a loan with respect to an existing
204-unit Senior Housing Facility known as The Palms, located in Fort
Myers, Florida. Construction of the Senior Housing Facility, which was
99% leased as of August 31, 1996, was completed in October 1988.

F-29

<PAGE>

Crown Villa, Omaha, Nebraska
----------------------------

In April 1991, ILM II acquired a loan with respect to a recently
completed 73-unit Senior Housing Facility known as Crown Villa, located
in Omaha, Nebraska. Construction of the Senior Housing Facility was
completed in January 1992. As of August 31, 1996, the project was 99%
leased.

Overland Park Place, Overland Park, Kansas
------------------------------------------

In April 1992, ILM II acquired a loan with respect to an existing
137-unit Senior Housing Facility known as Overland Park Place, located
in Overland Park, Kansas. Construction of the Senior Housing Facility
was completed in June 1984. As of August 31, 1996, the project was 91%
leased.

Rio Las Palmas, Stockton, California
------------------------------------

In May 1992, ILM II acquired a loan with respect to an existing
162-unit Senior Housing Facility known as Rio Las Palmas, located in
Stockton, California. Construction of the Senior Housing Facility was
completed in June 1988. As of August 31, 1996, the project was 90%
leased.

The Villa at Riverwood, St. Louis County, Missouri

In May 1992, ILM II acquired a loan with respect to an existing
119-unit Senior Housing Facility known as The Villa at Riverwood,
located in St. Louis County, Missouri. Construction of the Senior
Housing Facility was completed in June 1985. As of August 31, 1996, the
project was 94% leased.

Villa Santa Barbara, Santa Barbara, California
----------------------------------------------

In July 1992, ILM II acquired a loan with respect to an existing
123-unit Senior Housing Facility known as Villa Santa Barbara, located
in Santa Barbara, California. The acquisition and improvement of the
facility was financed by the aforementioned loan and another loan from
an affiliated company, PaineWebber Independent Living Mortgage Fund,
Inc. (ILM). Any amounts due from Angeles Housing with regard to the
mortgage loans on the Santa Barbara property will be equitably
apportioned between ILM II and ILM (generally 75% to ILM II and 25% to
ILM). ILM II and ILM have entered into an Intercreditor Agreement to
set forth their respective rights and entitlements under the loan
documents. Construction of the Senior Housing Facility was completed in
1979. As of August 31, 1996, the project was 81% leased. During the
first quarter of fiscal 1994, ILM II committed to release a portion of
the funds set aside for capital improvements at Villa Santa Barbara in
order to improve the marketability of the property. With the formal
execution of the Settlement Agreement completed, the planned
improvement program is now moving forward toward completion. ILM II's
financing of such a program is expected to total approximately $1
million, which it will fund from available uninvested offering
proceeds.

5. Mortgage Loans

The Company's operating properties were acquired subject to the participating
mortgage loans payable to ILM II. The principal balance of each loan was
modified to reflect the estimated fair value of the related operating property
as of the date of the Transfers. The modified Loans require interest-only
payments on a monthly basis at a rate of 7% from April 1, 1994 through December
31, 1994, 9% for the period January 1 through December 31, 1995, 11% for the
period January 1 through December 31, 1996, 12% for the period January 1 through
December 31, 1997, 13% for the period January 1 through December 31, 1998, 13.5%
for the period January 1 through December 31, 1999 and 14% for the period
January 1, 2000 through maturity, on December 31, 2000.

F-30

<PAGE>

The following loans were outstanding at August 31, 1996 and 1995.

Property
Pledged Aug. 31, Aug. 31, Date of
as Collateral 1996 1995 Loan
------------- ---- ---- ----
<S> <C> <C> <C>
The Palms $8,700,000 $8,700,000 7/18/90
Fort Myers, FL

Crown Villa 4,950,000 4,950,000 4/25/91
Omaha, NE

Overland Park Place 7,850,000 7,850,000 4/9/92
Overland Park, KS

Rio Las Palmas 5,700,000 5,700,000 5/14/92
Stockton, CA

The Villa at Riverwood 5,850,000 5,850,000 5/29/92
St. Louis County, MO

Villa Santa Barbara 5,094,000 4,774,000 7/13/92
Santa Barbara, CA
------------------- -----------------
$38,144,000 $37,824,000

Less discount (4,138,000) (4,138,000)
------------------- -----------------
$34,006,000 $33,686,000
=================== =================

</TABLE>

A discount was recorded on the long-term debt in the amount by which the
modified principal amount of the loans exceeded the historical cost basis of the
properties at the time of the Transfers.

6. Shareholders' Equity

The Company has issued 100 shares of Series A Preferred Stock to ILM II in
return for a capital contribution in the amount of $495,000. The holders of the
Series A Preferred Stock are entitled to one vote for each share of Preferred
Stock held. In addition, the holders of the Series A Preferred Stock are
entitled to receive, when and if declared by the Board of Directors, dividends
and distributions in an amount per share equal to the product of 0.1 and 99% of
the total amount of dividends and distributions made to all shareholders. The
Company has also issued 10,000 shares of Common Stock to PWP Holding in return
for a capital contribution in the amount of $5,000. The holders of the Common
Stock are entitled to one vote for each share of Common Stock held. The holders
of the Common Stock are entitled to receive, when and if declared by the Board
of Directors, dividends and distributions in an amount per share equal to the
product of 0.001 and 1% of the total amount of dividends and distributions made
to all shareholders.

7. Lease Arrangements

Beginning September 1, 1995, the Senior Housing Facilities were leased to ILM II
Lease Corporation under a master lease agreement. The master lease agreement, is
initially between the Company, as owner of the properties and Lessor, and ILM II
Lease Corporation as Lessee. The master lease is a "triple-net" lease whereby
the Lessee pays all operating expenses, governmental taxes and assessments,
utility charges and insurance premiums, as well as the costs of all required
maintenance, personal property and non-structural repairs in connection with the
operation of the Senior Housing Facilities. The Company, as the Lessor, is
responsible for all major capital improvements and structural repairs to the
Senior Housing Facilities. During the initial term of the master lease, which
expires on December 31, 2000 (December 31, 1999 with respect to the Santa
Barbara property), ILM II Lease Corporation is obligated to pay annual base rent
for the use of all of the Facilities in the aggregate amount of $3,548,700 for
calendar year 1995 (prorated based on the lease commencement date) and
$4,035,600 for calendar year 1996 and each subsequent year. Beginning in January
1997 and for the remainder of the lease term, ILM I Lease Corporation will also
be obligated to pay variable rent for each Senior Housing Facility. Such
variable rent will be payable quarterly and will equal 40% of the excess, if
any, of the aggregate total revenues for the Senior Housing Facilities, on an
annualized basis, over $13,021,000.

F-31
<PAGE>

A condensed balance sheet as of August 31, 1996 and summary of operations for
the year then ended of ILM II Lease Corporation are as follows:

Assets
-------
August 31, 1996
---------------
<S> <C>
Current Assets $1,714
Furniture, fixtures and equipment 183
Other non-current assets 38
==========
$1,935
==========

Liabilities and Shareholders' Equity
-------------------------------------
Current liabilities $1,045
Other non-current liabilities 131
Shareholders' equity 759
==========
$1,935
==========

Summary of Operations

Year ended
August 31, 1996

Revenues $13,201

Operating expenses 8,764
Master lease expense 4,004
Income tax expense 173
------------

Net income $ 260

============
</TABLE>

8. Legal Proceedings and Contingencies

Angeles Corporation Litigation

Angeles had guaranteed certain of the obligations of AHC under the terms of the
Exclusivity Agreement described in Note 1. Under the terms of the Settlement
Agreement discussed in Note 1, ILM II retained a general unsecured claim against
Angeles in the amount of $1,200,658 as part of the bankruptcy proceedings, but
waived all other claims against Angeles, including any amounts of base and
additional interest owed. In addition, ILM II maintained a claim for
approximately $408,000 against an affiliate of Angeles which had made a separate
guaranty to ILM II. On March 17, 1995, the Bankruptcy Court handling the Angeles
bankruptcy proceedings approved a final settlement of ILM II's outstanding
claims against Angeles and its affiliates. Pursuant to the terms of this
settlement, ILM II received a cash payment of $1 million on April 14, 1995 in
full satisfaction of the claims, which totaled approximately $1.6 million. This
amount, net of certain related legal expenses, was recorded as a reduction in
the carrying values of ILM II's operating investment properties.

F-32
<PAGE>

Schedule III - Real Estate and Accumulated Depreciation

ILM HOLDING INC. II
SCHEDULE OF REAL ESTATE AND ACCUMULATED DEPRECIATION
August 31, 1996
(Amounts in thousands)

<TABLE>
<CAPTION>
Costs
Capitalized
Initial Cost to (Removed) Gross Amount at Which Carried at
II.M (2) Subsequent to End of Year
------------------------- Acquisition ------------------------------------
Buildings & Buildings & Buildings &
Depreciation Encumbrances (1) Land Improvements Improvements Land Improvements Total
- ------------------ ----------------- ---------- ------------- ----------------- ---------- ------------- ----------
CONGREGATE CARE FACILITIES:
<S> <C> <C> <C> <C> <C> <C> <C>
Fort Myers, FL $ 8,700 $ 1,058 $ 6,065 $ 209 $ 1,058 $6,274 $ 7,332

Omaha, NE 4,950 390 3,032 105 390 3,137 3,527

Overland Park, KS 7,850 656 5,170 178 656 5,348 6,004

Stockton, CA 5,700 1,496 3,952 137 1,496 4,089 5,585

St. Louis County,
MO 5,850 280 3,480 120 280 3,600 3,880

Santa Barbara,
California 5,094 1,150 3,156 110 1,150 3,266 4,416
------------ -------- ---------- ----------- --------- --------- --------
$ 38,144 $ 5,030 $ 24,855 $ 859 $ 5,030 $ 25,714 $30,744
========== ======= ======== ======== ======= ======== =======

Life on
Which
Depreciation
in Latest
Income
Accumulated Date of Date Statement
Depreciation Depreciation Construction Acquired (2) is Computed
- ------------------ ------------- ------------- ------------- -------------
CONGREGATE CARE FACILITIES:

Fort Myers, FL $ 858 1988 4/1/94 5-40 yrs

Omaha, NE 338 1992 4/1/94 5-40 yrs.

Overland Park, KS 509 1984 4/1/94 5 - 40 yrs

Stockton, CA 418 1988 4/1/94 5 -40 yrs.

St. Louis County,
MO 363 1985 4/1/94 5 - 40 yrs

Santa Barbara,
California 282 1979 4/1/94 5 - 40 yrs.
---------
$ 2,768
========

</TABLE>

(1) Encumbrances represent first mortgage loans between the Company, as
mortgagor, and PaineWebber Independent Living Mortgage Fund Inc. II, as
mortgagee.

(2) Initial cost to the Company represents the cost at which the Facilities were
transferred to the Company effective April 1, 1994 pursuant to the Settlement
Agreement entered into between the Company and AHC as described in the Notes to
the Financial Statements.

(3) The aggregate cost of real estate owned at August 31, 1996 for Federal
income tax purposes is approximately $38,872,000.

F-33

<PAGE>

Schedule III - Real Estate and Accumulated Depreciation
- -------------------------------------------------------

ILM HOLDING INC. II
SCHEDULE OF REAL ESTATE AND ACCUMULATED DEPRECIATION
August 31, 1996
(Amounts in thousands)

(5) Reconciliation of real estate owned:
1996 1995
<S> <C> <C>
Balance at beginning of period $ 30,641 $ 29,313
Acquisitions and improvements - 12 months ended 8/31/96 103 -
Acquisitions and improvements - 12 months ended 6/30/95 - 1,189
Improvements - 3 months ended 6/30/94 - -
Improvements - 2 months ended 8/31/95 - 139
================ ================
Balance at end of period $ 30,744 $ 30,641
================ ================

(6) Reconciliation of accumulated depreciation:

Balance at beginning of period $ 1,641 $ 275
Depreciation expense - 12 months ended 8/31/96 1,127 -
Depreciation expense - 12 months ended 6/30/95 - 1,170
Depreciation expense - 3 months ended 6/30/94 - -
Depreciation expense - 2 months ended 8/31/95 - 196
================ ================
Balance at end of period $ 2,768 $ 1,641
================ ================

</TABLE>

F-34